Enron scandal
Encyclopedia
The Enron scandal, revealed in October 2001, eventually led to the bankruptcy
of the Enron Corporation
, an American energy
company based in Houston, Texas
, and the dissolution of Arthur Andersen
, which was one of the five largest
audit
and accountancy
partnership
s in the world. In addition to being the largest bankruptcy reorganization in American history at that time, Enron was attributed as the biggest audit failure.
Enron was formed in 1985 by Kenneth Lay
after merging Houston Natural Gas
and InterNorth
. Several years later, when Jeffrey Skilling
was hired, he developed a staff of executives that, through the use of accounting loopholes, special purpose entities
, and poor financial reporting, were able to hide billions in debt from failed deals and projects. Chief Financial Officer Andrew Fastow
and other executives not only misled Enron's board of directors and audit committee on high-risk accounting practices, but also pressured Andersen to ignore the issues.
Shareholders lost nearly $11 billion when Enron's stock price, which hit a high of US$
90 per share in mid-2000, plummeted to less than $1 by the end of November 2001. The U.S. Securities and Exchange Commission (SEC) began an investigation, and rival Houston competitor Dynegy
offered to purchase the company at a fire sale
price. The deal fell through, and on December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code
. Enron's $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history until WorldCom's bankruptcy the following year.
Many executives at Enron were indicted for a variety of charges and were later sentenced to prison. Enron's auditor, Arthur Andersen, was found guilty in a United States District Court, but by the time the ruling was overturned
at the U.S. Supreme Court
, the firm had lost the majority of its customers and had shut down. Employees and shareholders received limited returns in lawsuits, despite losing billions in pensions and stock prices. As a consequence of the scandal, new regulations and legislation were enacted to expand the accuracy of financial reporting for public companies. One piece of legislation, the Sarbanes-Oxley Act
, expanded repercussions for destroying, altering, or fabricating records in federal investigations or for attempting to defraud shareholders. The act also increased the accountability of auditing firms to remain unbiased and independent of their clients.
In 1985, Kenneth Lay
merged the natural gas pipeline
companies of Houston Natural Gas
and InterNorth
to form Enron. In the early 1990s, he helped to initiate the selling of electricity at market prices
and, soon after, the United States Congress passed legislation deregulating
the sale of natural gas
. The resulting markets made it possible for traders such as Enron to sell energy at higher prices, thereby significantly increasing its revenue. After producers and local governments decried the resultant price volatility
and pushed for increased regulation, strong lobbying
on the part of Enron and others, was able to keep the free market
system in place.
As Enron rose to become the largest seller of natural gas in North America by 1992, its gas contracts trading earned earnings before interest and taxes
of $122 million, the second largest contributor to the company's net income. The November 1999 creation of the EnronOnline trading website allowed the company to better manage its contracts trading business.
In an attempt to achieve further growth, Enron pursued a diversification strategy. The company owned and operated a variety of assets including gas pipelines, electricity plants, pulp and paper plants, water plants, and broadband services across the globe. The corporation also gained additional revenue by trading contracts for the same array of products and services it was involved in.
As a result, Enron's stock rose from the start of the 1990s until year-end 1998 by 311% percent, a significant increase over the rate of growth in the Standard & Poor 500 index
. The stock increased by 56% in 1999 and a further 87% in 2000, compared to a 20% increase and a 10% decline for the index during the same years. By December 31, 2000, Enron’s stock was priced at $83.13 and its market capitalization exceeded $60 billion, 70 times earnings
and six times book value
, an indication of the stock market’s high expectations about its future prospects. In addition, Enron was rated the most innovative large company in America in Fortunes Most Admired Companies survey.
did not clearly depict its operations and finances with shareholders and analysts. In addition, its complex business model
and unethical practices required that the company use accounting limitations to misrepresent earnings and modify the balance sheet
to portray a favorable depiction of its performance. According to McLean and Elkid in their book The Smartest Guys in the Room, "The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control." In an article by James Bodurtha, Jr., he argues that from 1997 until its demise, "the primary motivations for Enron's accounting and financial transactions seem to have been to keep reported income
and reported cash flow
up, asset values
inflated, and liabilities off the books
."
The combination of these issues later led to the bankruptcy of the company, and the majority of them were perpetuated by the indirect knowledge or direct actions of Lay, Jeffrey Skilling
, Andrew Fastow
, and other executives. Lay served as the chairman of the company in its last few years, and approved of the actions of Skilling and Fastow although he did not always inquire about the details. Skilling, constantly focused on meeting Wall Street expectations, pushed for the use of mark-to-market accounting and pressured Enron executives to find new ways to hide its debt. Fastow and other executives "...created off-balance-sheet vehicles, complex financing structures, and deals so bewildering that few people can understand them even now."
in addition to building and maintaining electric power plants, natural gas pipelines, storage, and processing facilities. When taking on the risk of buying and selling products, merchants are allowed to report the selling price as revenues and the products' costs as cost of goods sold
. In contrast, an "agent
" provides a service to the customer, but does not take on the same risks as merchants for buying and selling. Service provider
s, when classified as agents, are able to report trading and brokerage fees as revenue, although not for the full value of the transaction.
How Fastow's Partnerships Worked (based on Enron 10-K)
Although trading firms such as Goldman Sachs
and Merrill Lynch
used the conventional "agent model" for reporting revenue (where only the trading or brokerage fee would be reported as revenue), Enron instead elected to report the entire value of each of its trades as revenue. This "merchant model" approach was considered much more aggressive in the accounting interpretation than the agent model. Enron's method of reporting inflated trading revenue was later adopted by other companies in the energy trading industry in an attempt to stay competitive with the company's large increase in revenue. Other energy companies such as Duke Energy
, Reliant Energy
, and Dynegy
joined Enron in the top 50 of the Fortune 500
mainly due to their adoption of the same trading revenue accounting approach as Enron.
Between 1996 to 2000, Enron's revenues increased by more than 750%, rising from $13.3 billion in 1996 to $100.8 billion in 2000. This extensive expansion of 65% per year was unprecedented in any industry, including the energy industry which typically considered growth of 2–3% per year to be respectable. For just the first nine months of 2001, Enron reported $138.7 billion in revenues, which placed the company at the sixth position on the Fortune Global 500
.
, the company listed actual costs of supplying the gas and actual revenues received from selling it. However, when Skilling joined the company, he demanded that the trading business adopt mark-to-market accounting, citing that it would reflect "... true economic value." Enron became the first non-financial company to use the method to account for its complex long-term contracts. Mark-to-market accounting requires that once a long-term contract was signed, income was estimated as the present value of net future cash flows. Often, the viability of these contracts and their related costs were difficult to judge. Due to the large discrepancies of attempting to match profits and cash, investors were typically given false or misleading reports. While using the method, income from projects could be recorded, which increased financial earnings. However, in future years, the profits could not be included, so new and additional income had to be included from more projects to develop additional growth to appease investors. As one Enron competitor pointed out, "If you accelerate your income, then you have to keep doing more and more deals to show the same or rising income." Despite potential pitfalls, the U.S. Securities and Exchange Commission (SEC) approved the accounting method for Enron in its trading of natural gas futures contracts on January 30, 1992. However, Enron later expanded its use to other areas in the company to help it meet Wall Street projections.
For one contract, in July 2000, Enron and Blockbuster Video signed a 20-year agreement to introduce on-demand entertainment to various U.S. cities by year-end. After several pilot projects, Enron recognized estimated profits of more than $110 million from the deal, even though analysts questioned the technical viability and market demand of the service. When the network failed to work, Blockbuster pulled out of the contract. Enron continued to recognize future profits, even though the deal resulted in a loss.
s. The company elected to disclose minimal details on its use of special purpose entities. These shell firms
were created by a sponsor, but funded by independent equity investors and debt financing. For financial reporting purposes, a series of rules dictates whether a special purpose entity is a separate entity from the sponsor. In total, by 2001, Enron had used hundreds of special purpose entities to hide its debt.
The special purpose entities were used for more than just circumventing accounting conventions. As a result of one violation, Enron's balance sheet understated its liabilities and overstated its equity
, and its earnings were overstated. Enron disclosed to its shareholders that it had hedged
downside risk in its own illiquid
investments using special purpose entities. However, the investors were oblivious to the fact that the special purpose entities were actually using the company's own stock and financial guarantees to finance these hedges. This setup prevented Enron from being protected from the downside risk. Notable examples of special purpose entities that Enron employed were JEDI, Chewco, Whitewing, and LJM.
, the California state pension fund, called the Joint Energy Development Investments (JEDI). In 1997, Skilling, serving as Chief Operating Officer
(COO), asked CalPERS to join Enron in a separate investment. CalPERS was interested in the idea, but only if it could be removed as a partner in JEDI. However, Enron did not want to show any debt from taking over CalPERS' stake in JEDI on its balance sheet. Chief Financial Officer
(CFO) Fastow developed the special purpose entity Chewco Investments
L.P.
which raised debt guaranteed by Enron and was used to acquire CalPER's joint venture stake for $383 million. Because of Fastow's organization of Chewco, JEDI's losses were kept off of Enron's balance sheet.
In fall 2001, CalPERS and Enron's arrangement was discovered, which required the discontinuation of Enron's prior accounting approach for Chewco and JEDI. This disqualification revealed that Enron's reported earnings from 1997 to mid-2001 would need to be reduced by $405 million and that the company's indebtedness would rise by $628 million.
is native to Texas, and was also the name of a special purpose entity used as a financing vehicle by Enron. In December 1997, with funding of $579 million provided by Enron and $500 million by an outside investor, Whitewing Associates L.P. was formed. Two years later, the entity's arrangement was changed so that it would no longer be consolidated with Enron and be counted on the company's balance sheet. Whitewing was used to purchase Enron assets, including stakes in power plants, pipelines, stocks, and other investments. Between 1999 and 2001, Whitewing bought assets from Enron worth $2 billion, using Enron stock as collateral
. Although the transactions were approved by the Enron board, the assets transfers were not true sales and should have been treated instead as loans.
, J.P. Morgan Chase, Credit Suisse First Boston
, Citigroup
, and other investors. Merrill Lynch
, which marketed the equity, also contributed $22 million to support the entities.
Enron transferred to "Raptor I-IV", four LJM-related special purpose entities named after the velociraptor
s in Jurassic Park
, more than "$1.2 billion in assets, including millions of shares of Enron common stock
and long term rights to purchase millions more shares, plus $150 million of Enron notes payable" as disclosed in the company's financial statement footnotes. The special purpose entities had been used to pay for all of this using the entities' debt instruments
. The footnotes also declared that the instruments' face amount totaled $1.5 billion, and the entities notional amount
of $2.1 billion had been used to enter into derivative contracts with Enron.
Enron capitalized the Raptors, and, in a manner similar to the accounting that's employed when a company issues stock at a public offering, then booked the notes payable issued as assets on its balance sheet
while increasing the shareholders' equity for the same amount. This treatment later became an issue for Enron and its auditor Arthur Andersen
as removing it from the balance sheet resulted in a $1.2 billion decrease in net shareholder equity.
Eventually the derivative contracts worth $2.1 billion lost significant value. Swap
s were established at the point the stock price hit its high points. Over a year the value of the portfolio under the swaps fell by $1.1 billion as the stock prices dropped (the loss in value meant that the special purpose entities technically now owed Enron $1.1 billion under the contracts). Enron, which used a "fair value" accounting method, claimed a $500 million gain on the swap contracts in its 2000 annual report
. The gain was responsible for offsetting its stock portfolio losses and was attributed to nearly a third of Enron's earnings for 2000 (before it was properly restated in 2001).
comprising predominantly outsiders with significant ownership stakes and a talented audit committee. In its 2000 review of best corporate boards, Chief Executive included Enron among its top five boards. Even with its complex corporate governance and network of intermediaries, Enron was still able to "attract large sums of capital to fund a questionable business model, conceal its true performance through a series of accounting and financing maneuvers, and hype its stock to unsustainable levels."
that became obsessed with a focus only on short-term earnings to maximize bonuses. Employees constantly looked to start high-volume deals, often disregarding the quality of cash flow or profits, in order to get a higher rating for their performance review. In addition, accounting results were recorded as soon as possible to keep up with the company's stock price. This practice helped ensure deal-makers and executives received large cash bonuses and stock options.
The company was constantly focusing on its stock price. Management was extensively compensated using stock options, similar to other U.S. companies. This setup of stock option awards caused management to create expectations of rapid growth in efforts to give the appearance of reported earnings to meet Wall Street's expectations. The stock ticker was located in lobbies, elevators, and on company computers. At budget meetings, Skilling would develop target earnings by asking "What earnings do you need to keep our stock price up?" and that number would be used, even if it was not feasible. At December 31, 2000, Enron had 96 million shares outstanding under stock option plans
(approximately 13% of common shares outstanding). Enron's proxy statement stated that, within three years, these awards were expected to be exercised. Using Enron's January 2001 stock price of $83.13 and the directors’ beneficial ownership reported in the 2001 proxy, the value of director stock ownership was $659 million for Lay, and $174 million for Skilling.
Skilling believed that if employees were constantly cost-centered, it would hinder original thinking. As a result, extravagant spending was rampant throughout the company, especially among the executives. Employees had large expense accounts and many executives were paid sometimes twice as much as competitors. In 1998, the top 200 highest-paid employees received $193 million from salaries, bonuses, and stock. Two years later, the figure jumped to $1.4 billion.
. Enron established long-term fixed commitments which needed to be hedged to prepare for the inevitable fluctuation of future energy prices. Enron's bankruptcy downfall was attributed to its reckless use of derivatives and special purpose entities. By hedging its risks with special purpose entities which it owned, Enron retained the risks associated with the transactions. This setup had Enron implementing hedges with itself.
Enron's aggressive accounting practices were not hidden from the board of directors, as later learned by a Senate subcommittee. The board was informed on the rationale for using the Whitewing, LJM, and Raptor transactions, and after approving them, received status updates on the entities' operations. Although not all of Enron's widespread improper accounting practices were revealed to the board, the practices were dependent on board decisions. Even though Enron extensively relied on derivatives for its business, the company's Finance Committee and board did not have comprehensive backgrounds in derivatives to grasp what they were being told. The Senate subcommittee argued that had there been a detailed understanding of how the derivatives were organized, the board would have prevented their use.
, was accused of applying reckless standards in its audits because of a conflict of interest
over the significant consulting fees generated by Enron. In 2000, Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees (this amount accounted for roughly 27% of the audit fees of public clients for Arthur Andersen's Houston office). The firms' methods were questioned as either being completed solely to receive its annual fees or for its lack of expertise in properly reviewing Enron's revenue recognition, special entities, derivatives, and other accounting practices.
Enron hired numerous Certified Public Accountant
s (CPA) as well as accountants who had worked on developing accounting rules with the Financial Accounting Standards Board
(FASB). The accountants looked for new ways to save the company money, including capitalizing on loopholes found in Generally Accepted Accounting Principles
(GAAP), the accounting industry's standards. One Enron accountant revealed "We tried to aggressively use the literature [GAAP] to our advantage. All the rules create all these opportunities. We got to where we did because we exploited that weakness."
Andersen's auditors were pressured by Enron's management to defer recognizing the charges from the special purpose entities as its credit risk
s became clear. Since the entities would never return a profit, accounting guidelines required that Enron should take a write-off
, where the value of the entity was removed from the balance sheet at a loss. To pressure Andersen into meeting Enron's earnings expectations, Enron would occasionally allow accounting firms Ernst & Young
or PricewaterhouseCoopers
to complete accounting tasks to create the illusion of hiring a new firm to replace Andersen. Although Andersen was equipped with internal controls to protect against conflicted incentives of local partners, it failed to prevent conflict of interest. In one case, Andersen's Houston office, which performed the Enron audit, was able to overrule any critical reviews of Enron's accounting decisions by Andersen's Chicago partner. In addition, after news of SEC investigations of Enron were made public, Andersen would later shred several tons of supporting documents and deleting nearly 30,000 e-mails and computer files, raising accusations of a cover-up.
Revelations concerning Andersen's overall performance led to the break-up of the firm, and to the following assessment by the Powers Committee (appointed by Enron's board to look into the firm's accounting in October 2001): "The evidence available to us suggests that Andersen did not fulfill its professional responsibilities in connection with its audits of Enron's financial statements, or its obligation to bring to the attention of Enron's Board (or the Audit and Compliance Committee) concerns about Enron's internal contracts over the related-party transactions".
Enron's audit committee was later criticized for its brief meetings that would cover large amounts of material. In one meeting on February 12, 2001, the committee met for an hour and a half. Enron's audit committee did not have the technical knowledge to properly question the auditors on accounting questions related to the company's special purpose entities. The committee was also unable to question the company's management due to pressures placed on the committee. The Permanent Subcommittee on Investigations of the Committee on Governmental Affairs
' report accused the board members of allowing conflicts of interest to impede their duties as monitoring the company's accounting practices. When Enron fell, the audit committee's conflicts of interest were regarded with suspicion.
In 1998, when analysts were given a tour of the Enron Energy Services
office, they were impressed with how the employees were working so vigorously. In reality, Skilling had moved other employees to the office from other departments (instructing them to pretend to work hard) to create the appearance that the division was bigger than it was. This ruse was used several times to fool analysts about the progress of different areas of Enron to help improve the stock price.
's Fortune
article Is Enron Overpriced? questioned how Enron could maintain its high stock value, which was trading at 55 times its earnings. She pointed out how analysts and investors did not know exactly how Enron was earning its income. McLean was first drawn to the company's situation after an analyst suggested she view the company's 10-K report
, where she found "strange transactions", "erratic cash flow", and "huge debt." She called Skilling to discuss her findings prior to publishing the article, but he brushed her off, calling her "unethical" for not properly researching the company. Fastow cited to Fortune reporters that Enron could not reveal earnings details as the company had over 1,200 trading books for assorted commodities and did "... not want anyone to know what's on those books. We don't want to tell anyone where we're making money."
In a conference call on April 17, 2001, then-Chief Executive Officer
(CEO) Skilling verbally attacked Wall Street analyst Richard Grubman, who questioned Enron's unusual accounting practice during a recorded conference call. When Grubman complained that Enron was the only company that could not release a balance sheet along with its earnings statements, Skilling replied "Well, thank you very much, we appreciate that ... asshole." This became an inside joke among many Enron employees, mocking Grubman for his perceived meddling rather than Skilling's lack of tact, with slogans such as "Ask Why, Asshole". However, Skilling's comment was met with dismay and astonishment by press and public, as he had previously brushed off criticism of Enron coolly or humorously, and many believe that this lack of restraint symbolized a downward spiral that would unravel the company's deceptive practices.
By the late 1990s Enron's stock was trading for $80–90 per share, and few seemed to concern themselves with the opacity of the company's financial disclosures. In mid-July 2001, Enron reported revenues of $50.1 billion, almost triple year-to-date, and beating analysts' estimates by 3 cents a share. Despite this, Enron's profit margin had stayed at a modest average of about 2.1%, and its share price had dropped by over 30% since the same quarter of 2000.
As time passed, a number of serious concerns confronted the company. Enron had recently faced several serious operational challenges, namely logistical difficulties in running a new broadband communications trading unit, and the losses from constructing the Dabhol Power project
, a large power plant in India. There was also mounting criticism of the company for the role that its subsidiary Enron Energy Services
had played in the power crisis of California in 2000–2001
.
On August 14, Skilling announced he was resigning his position as CEO after only six months. Skilling had long served as president and COO before being promoted to CEO. Skilling cited personal reasons for leaving the company. Observers noted that in the months leading up to his exit, Skilling had sold at minimum 450,000 shares of Enron at a value of around $33 million (though he still owned over a million shares at the date of his departure). Nevertheless, Lay, who was serving as chairman at Enron, assured stunned market watchers that there would be "no change in the performance or outlook of the company going forward" from Skilling's departure. Lay announced he himself would re-assume the position of chief executive officer.
The next day, however, Skilling admitted that a very significant reason for his departure was Enron's faltering price in the stock market. The columnist Paul Krugman
, writing in The New York Times, asserted that Enron was an illustration of the consequences that occur from the deregulation and commodification of things such as energy. A few days later, in a letter to the editor, Kenneth Lay defended Enron and the philosophy behind the company:
On August 15, Sherron Watkins
, vice president for corporate development, sent an anonymous letter to Lay warning him about the company's accounting practices. One statement in the letter said "I am incredibly nervous that we will implode in a wave of accounting scandals." Watkins contacted a friend who worked for Arthur Andersen and he drafted a memo to give to the audit partners over the points she raised. On August 22, Watkins individually met with Lay and gave him a six-page letter further explaining Enron's accounting issues. Lay questioned her as to whether she had told anyone outside of the company and then vowed to have the company's law firm, Vinson & Elkins, review the issues, although she argued that using the firm would present a conflict of interest. Lay consulted with other executives, and although they wanted to fire Watkins (as Texas law did not protect company whistleblower
s), they decided against it to prevent a lawsuit. On October 15, Vinson & Elkins announced that Enron had done nothing wrong in its accounting practices as Andersen had approved each issue.
of Enron's accounting books made proper assessment difficult for Wall Street. In addition, the company admitted to repeatedly using "related-party transactions," which some feared could be too-easily used to transfer losses that might otherwise appear on Enron's own balance sheet. A particularly troubling aspect of this technique was that several of the "related-party" entities had been or were being controlled by CFO Fastow.
After the September 11, 2001 attacks
, media attention shifted away from the company and its troubles; a little less than a month later Enron announced its intention to begin the process of shearing its lower-margin assets in favor of its core businesses of gas and electricity trading. This move included selling Portland General Electric
to another Oregon utility, Northwest Natural Gas, for about $1.9 billion in cash and stock, and possibly selling its 65% stake in the Dabhol project in India.
said "I don't think anyone knows what the broadband operation is worth."
Enron's management team claimed the losses were mostly due to investment losses, along with charges such as about $180 million in money spent restructuring the company's troubled broadband trading unit. In a statement, Lay revealed, "After a thorough review of our businesses, we have decided to take these charges to clear away issues that have clouded the performance and earnings potential of our core energy businesses." Some analysts were unnerved. David Fleischer
at Goldman Sachs
, an analyst called previously 'one of the company's strongest supporters' asserted that the Enron management "... lost credibility and have to reprove themselves. They need to convince investors these earnings are real, that the company is for real and that growth will be realized."
Fastow disclosed to Enron's board of directors
on October 22 that he earned $30 million from compensation arrangements when managing the LJM limited partnerships. That day, the share price of Enron fell to $20.65, down $5.40 in one day, following the announcement by the SEC that it was investigating several suspicious deals struck by Enron, characterizing them as "some of the most opaque transactions with insiders ever seen". Attempting to explain the billion-dollar charge and calm investors, Enron's disclosures spoke of "share settled costless collar arrangements," "derivative instruments which eliminated the contingent nature of existing restricted forward contract
s," and strategies that served "to hedge certain merchant investments and other assets." Such puzzling phraseology left many analysts feeling ignorant about just how Enron ran its business. Regarding the SEC investigation, chairman and CEO Lay said, "We will cooperate fully with the S.E.C. and look forward to the opportunity to put any concern about these transactions to rest."
on October 23, in which he attempted to reassure investors that the company's cash resources were ample and no further "one-time charges" loomed. Secondly, Lay adamantly insisted there were no improprieties regarding Enron's transactions with partnerships run by Fastow and emphasized his support for the CFO. David Fleischer, the analyst at Goldman, was again skeptical, telling Lay and Fastow, "There is an appearance that you are hiding something." Nevertheless, Fleischer persisted in recommending the stock, arguing that he didn't "think accountants and auditors would have allowed total shenanigans." Lay also attempted to reassure the conferees by stressing that all of Enron's financial and accounting maneuvers had been scrutinized by their auditor, Arthur Andersen. After several questioners pressed the issue, Lay stated Enron management would "look into providing" more detailed statements for the end of better understanding the company's relationship with the special entities as those run by Fastow.
Two days later, on October 25, despite his reassurances days earlier, Lay removed Fastow from his position, citing "In my continued discussions with the financial community, it became clear to me that restoring investor confidence would require us to replace Andy as CFO." However, with Skilling and Fastow now both departed, some analysts feared that shedding light on the company's practices would be made all the more difficult. Enron's stock was now trading at $16.41, having lost half its value in a little over a week.
On October 27 the company began buying back all its commercial paper
, valued at around $3.3 billion, in an effort to calm investor fears about Enron's supply of cash. Enron financed the re-purchase by depleting its lines of credit
at several banks. While the company's debt rating was still considered investment-grade, its bonds
were trading at levels slightly below, making future sales problematic.
As the month came to a close, serious concerns were being raised by some observers regarding Enron's possible manipulation of accepted accounting rules; however, analysis was claimed to be impossible based on the incomplete information provided by Enron. Industry analysts openly feared that Enron was the new Long-Term Capital Management
, the hedge fund whose collapse in 1998 threatened systemic failure in the international financial markets. Enron's tremendous presence worried some about the consequences of the company's possible collapse. Enron executives were tight-lipped, accepting questions in written form only.
and Fitch
, two of the three biggest credit-rating agencies, had slated Enron for review for possible downgrade. Such a downgrade would force Enron to issue millions of shares of stock to cover loans it had guaranteed, a move that would bring down the value of existing stock further. Additionally, all manner of companies began reviewing their existing contracts with Enron, especially in the long term, in the event that Enron's rating were lowered below investment grade, a possible hindrance in future transactions.
Analysts and observers continued their chorus of complaints regarding Enron's difficulty or impossibility of properly assessing a company whose financial statements were so mysterious. Some feared that no one at Enron apart from Skilling and Fastow could completely explain years of mysterious transactions. "You're getting way over my head," said Lay in late August 2001 in response to detailed questions about Enron's business, a reaction that worried analysts.
On October 29, responding to growing concerns that Enron might have insufficient cash on hand, news spread that Enron was seeking a further $1–2 billion in financing from banks. The next day, as feared, Moody's lowered Enron's credit rating from Baa1 to Baa2, two levels above junk status. Standard & Poor's also lowered Enron's rating to BBB+, the equivalent of Moody's rating. Moody's also warned that it would downgrade Enron's commercial paper rating, the consequence of which would likely prevent the company from finding the further financing it sought to keep solvent.
November began with the disclosure that the SEC was now pursuing a formal investigation, prompted by questions related to Enron's dealings with "related parties". Enron's board also announced that it would commission a special committee to investigate the transactions, headed by William C. Powers
, the dean of the University of Texas law school. The next day, an editorial in The New York Times called for an "aggressive" investigation into the matter. Enron was able to secure an additional $1 billion in financing from cross-town rival Dynegy
on November 2, but the news was not universally admired in that the debt was secured by assets from the company's valuable Northern Natural Gas and Transwestern Pipeline
.
After it received a wide spectrum of rejections, Enron management apparently found a buyer when the board of Dynegy, another energy trader based in Houston, voted late at night on November 7 to acquire Enron at a fire-sale price of about $8 billion in stock. Chevron Texaco
, which at the time owned about a quarter of Dynegy, agreed to provide Enron with $2.5 billion in cash, specifically $1 billion up front and the rest when the deal was completed. Dynegy would also be required to assume nearly $13 billion of debt, plus any other debt hitherto occluded by the Enron management's secretive business practices, possibly as much as $10 billion in "hidden" debt. Dynegy and Enron confirmed their deal on November 8, 2001.
Commentators remarked on the different corporate cultures between Dynegy and Enron, and on the "straight-talking" personality of the CEO of Dynegy, Charles Watson. Some wondered if Enron's troubles had not simply been the result of innocent accounting errors. By November, Enron was asserting that the billion-plus "one-time charges" disclosed in October should in reality have been $200 million, with the rest of the amount simply corrections of dormant accounting mistakes. Many feared other "mistakes" and restatements might yet be revealed.
Another major correction of Enron's earnings was announced on November 9, with a reduction of $591 million over the stated revenue of years 1997–2000. The charges were said to come largely from two special purpose partnerships (JEDI and Chewco). The corrections resulted in the virtual elimination of profit for fiscal year 1997, with significant reductions for the other years. Despite this disclosure, Dynegy declared it still intended to purchase Enron. Both companies were said to be anxious to receive an official assessment of the proposed sale from Moody's and S&P presumably to understand the effect the completion of any buyout transaction would have on Dynegy and Enron's credit rating. In addition, concerns were raised regarding antitrust regulatory hurdles leading to possible divestiture, along with what to some observers were the radically different corporate cultures of Enron and Dynegy.
Both companies pushed aggressively for the deal, and some observers were hopeful; Watson was praised for his vision in attempting to create the biggest presence on the energy market. At the time, Watson said "We feel [Enron] is a very solid company with plenty of capacity to withstand whatever happens the next few months." One analyst called the deal "a whopper [...] a very good deal financially, certainly should be a good deal strategically, and provides some immediate balance-sheet backstop for Enron."
Credit issues were becoming more critical, however. Around the time the buyout was made public, Moody's and S&P both lowered Enron's rating to just one notch above junk status. Were the company's rating to fall below investment-grade, its ability to trade would be severely limited if there was a reduction or elimination of its credit lines with competitors. In a conference call, S&P affirmed that, were Enron not to be taken over, S&P would cut its rating to low BB or high B, ratings noted as being within junk status. In addition, many traders had limited their involvement with Enron, or stopped doing business altogether, fearing more bad news. Watson again attempted to re-assure, attesting at a presentation to investors that there was "nothing wrong with Enron's business". He also acknowledged that remunerative steps (in the form of more stock options) would have to be taken to redress the animosity of many Enron employees for management after it was revealed that Lay and other top officials had sold hundreds of millions of dollars worth of stock in the months leading up to the crisis. The situation was not helped by the disclosure that Lay, his "reputation in tatters", stood to receive a payment of $60 million as a change-of-control fee subsequent to the Dynegy acquisition, while many Enron employees had seen their retirement accounts, which were largely based on Enron stock, decimated as the price fell 90% in a year. An official at a company owned by Enron stated "We had some married couples who both worked who lost as much as $800,000 or $900,000. It pretty much wiped out every employee's savings plan."
Watson assured investors that the true nature of Enron's business had been made clear to him: "We have comfort there is not another shoe to drop. If there is no shoe, this is a phenomenally good transaction." Watson further asserted that Enron's energy trading part alone was worth the price Dynegy was paying for the whole company.
By mid-November, Enron announced it was planning to sell about $8 billion worth of underperforming assets, along with a general plan to reduce its scale for the sake of financial stability. On November 19 Enron disclosed to the public further evidence of its critical state of affairs. Most pressingly that the company was facing debt repayment obligations in the range of $9 billion by the end of 2002. Such debts were "vastly in excess" of its available cash. Also, the success of measures to preserve its solvency were not guaranteed, specifically as regarded asset sales and debt refinancing. In a statement, Enron revealed "An adverse outcome with respect to any of these matters would likely have a material adverse impact on Enron's ability to continue as a going concern."
Two days later, on November 21, Wall Street expressed serious doubts that Dynegy would proceed with its deal at all, or would seek to radically renegotiate. Furthermore Enron revealed in a 10-Q filing
that almost all the money it had recently borrowed for purposes including buying its commercial paper, or about $5 billion, had been exhausted in just 50 days. Analysts were unnerved at the revelation, especially since Dynegy was reported to also have been unaware of Enron's rate of cash use. In order to walk away from the proposed buyout, Dynegy would need to legally demonstrate a "material change" in the circumstances of the transaction; as late as November 22, sources close to Dynegy were skeptical that the latest revelations constituted sufficient grounds.
The SEC announced it had filed civil fraud complaints against Andersen. A few days later, sources claimed Enron and Dynegy were renegotiating the terms of their arrangement. Dynegy now demanded Enron agree to be bought for $4 billion rather than the previous $8 billion. Observers were reporting difficulties in ascertaining whether or which of Enron's operations, if any, were profitable. Reports described an en masse shift of business to Enron's competitors for the sake of risk exposure reduction.
On November 28, 2001, Enron's two worst-possible outcomes came true. Dynegy Inc. unilaterally disengaged from the proposed acquisition of the company and Enron's credit rating fell to junk status. Watson later said "At the end, you couldn't give it [Enron] to me." The company, having very little cash with which to run its business, let alone satisfy enormous debts, imploded. Its stock price fell to $0.61 at the end of the day's trading. One editorial observer wrote that "Enron is now shorthand for the perfect financial storm."
Systemic consequences were felt, as Enron's creditors and other energy trading companies suffered the loss of several percentage points. Some analysts felt Enron's failure highlighted the risks of the post–September 11 economy, and encouraged traders to lock in profits where they could. The question now became how to determine the total exposure of the markets and other traders to Enron's failure. Early figures put the number at $18.7 billion. One adviser stated, "We don't really know who is out there exposed to Enron's credit. I'm telling my clients to prepare for the worst."
Enron was estimated to have about $23 billion in liabilities from both debt outstanding and guaranteed loans. Citigroup
and JP Morgan Chase in particular appeared to have significant amounts to lose with Enron's fall. Additionally, many of Enron's major assets were pledged to lenders in order to secure loans, throwing into doubt what if anything unsecured creditors and eventually stockholders might receive in bankruptcy proceedings.
Enron's European operations filed for bankruptcy on November 30, 2001, and it sought Chapter 11 protection two days later on December 2. It was the largest bankruptcy
in U.S. history (before being surpassed by WorldCom's bankruptcy the following year), and resulted in 4,000 lost jobs. The day that Enron filed for bankruptcy, the employees were told to pack up their belongings and were given 30 minutes to vacate the building. Nearly 62% of 15,000 employees' savings plans relied on Enron stock that was purchased at $83 in early 2001 and was now practically worthless.
On January 17, 2002 Enron fired Arthur Andersen as its auditor, citing its accounting advice and the destruction of documents. Andersen countered that it had already severed ties with the company when Enron entered bankruptcy.
, insider trading
, and conspiracy, among other crimes. Fastow pleaded guilty to two charges of conspiracy and was sentenced to ten years with no parole in a plea bargain to testify against Lay, Skilling, and Causey. Lea was indicted on six felony counts, but prosecutors later dropped them in favor of a single misdemeanor tax charge. Lea was sentenced to one year for helping her husband hide income from the government.
Lay and Skilling went on trial for their part in the Enron scandal in January 2006. The 53-count, 65-page indictment
covers a broad range of financial crimes, including bank fraud, making false statements to banks and auditors, securities fraud, wire fraud, money laundering, conspiracy, and insider trading. District Judge
Sim Lake had previously denied motions by the defendants to hold separate trials and to move the case out of Houston, where the defendants argued the negative publicity surrounding Enron's demise would make it impossible to get a fair trial. On May 25, 2006, the jury in the Lay and Skilling trial returned its verdicts. Skilling was convicted of 19 of 28 counts of securities fraud and wire fraud and acquitted on the remaining nine, including charges of insider trading
. He was sentenced to 24 years and 4 months in prison.
Lay pleaded not guilty to the eleven criminal charges, and claimed that he was misled by those around him. He attributed the main cause for the company's fall to Fastow. Lay was convicted of all six counts of securities and wire fraud for which he had been tried, and he faced a total sentence of up to 45 years in prison. However, before sentencing was scheduled, Lay died on July 5, 2006. At the time of his death, the SEC had been seeking more than $90 million from Lay in addition to civil fines. The case surrounding Lay's wife, Linda, is a difficult one. She sold roughly 500,000 shares of Enron ten minutes to thirty minutes before the information that Enron was collapsing went public on November 28, 2001. Linda was never charged with any of the events related to Enron.
Although Michael Kopper worked at Enron for over seven years, Lay did not know of Kopper even after the company's bankruptcy. Kopper was able to keep his name anonymous in the entire affair, as the spotlight remained on Fastow. Kopper was the first Enron executive to plead guilty. Chief Accounting Officer Rick Causey was indicted with six felony charges for disguising Enron's financial shape during his tenure. After pleading not guilty, he later switched to guilty and was sentenced to seven years in prison.
All told, sixteen people pleaded guilty for crimes committed at the company, and five others, including four former Merrill Lynch
employees, were found guilty. Eight former Enron executives testified—the star witness being Fastow—against Lay and Skilling, his former bosses. Another was Kenneth Rice, the former chief of Enron Corp.'s high-speed Internet unit, who cooperated and whose testimony helped convict Skilling and Lay. In June 2007, he received a 27-month sentence.
for shredding the thousands of documents and deleting e-mails and company files that tied the firm to its audit of Enron. Although only a small number of Arthur Andersen's employees were involved with the scandal, the firm was effectively put out of business; the SEC is not allowed to accept audits from convicted felons. The firm surrendered its CPA license on August 31, 2002, and 85,000 employees lost their jobs. The conviction was later overturned
by the U.S. Supreme Court
due to the jury not being properly instructed
on the charge against Andersen. The Supreme Court ruling theoretically left Andersen free to resume operations. However, the damage to the Andersen name has been so great that it has not returned as a viable business even on a limited scale.
. The three British men had worked with Fastow on a special purpose entity he had started called Swap Sub. When Fastow was being investigated by the SEC, the three men met with the British Financial Services Authority
(FSA) in November 2001 to discuss their interactions with Fastow. In June 2002, the U.S. issued warrants for their arrest on seven counts of wire fraud, and they were then extradited. On July 12, a potential Enron witness scheduled to be extradited to the U.S., Neil Coulbeck
, was found dead in a park in north-east London. The U.S. case alleged that Coulbeck and others conspired with Fastow. In a plea bargain in November 2007, the trio plead guilty to one count of wire fraud while the other six counts were dropped. Darby, Bermingham, and Mulgrew were each sentenced to 37 months in prison. In August 2010, Bermingham and Mulgrew retracted their confessions.
Enron's shareholders lost $74 billion in the four years before the company's bankruptcy ($40 to $45 billion was attributed to fraud). As Enron had nearly $67 billion that it owed creditors, employees and shareholders received limited, if any, assistance aside from severance from Enron. To pay its creditors, Enron held auctions to sell assets including art, photographs, logo signs, and its pipelines.
More than 20,000 of Enron's former employees in May 2004 won a suit of $85 million for compensation of $2 billion that was lost from their pensions. From the settlement, the employees each received about $3,100. The following year, investors received another settlement from several banks of $4.2 billion. In September 2008, a $7.2-billion settlement from a $40-billion lawsuit, was reached on behalf of the shareholders. The settlement was distributed among the lead plaintiff, University of California
(UC), and 1.5 million individuals and groups. UC's law firm Coughlin Stoia Geller Rudman and Robbins
, received $688 million in fees, the highest in a U.S. securities fraud case. At the distribution, UC announced in a press release "We are extremely pleased to be returning these funds to the members of the class. Getting here has required a long, challenging effort, but the results for Enron investors are unprecedented."
and the House Committee on Financial Services
held multiple hearings about the collapse of Enron and related accounting and investor protection issues. These hearings and the corporate scandals that followed Enron led to the passage of the Sarbanes-Oxley Act on July 30, 2002. The Act is nearly "a mirror image of Enron: the company's perceived corporate governance failings are matched virtually point for point in the principal provisions of the Act."
The main provisions of the Sarbanes-Oxley Act included the establishment of the Public Company Accounting Oversight Board
to develop standards for the preparation of audit reports; the restriction of public accounting firms from providing any non-auditing services when auditing; provisions for the independence of audit committee members, executives being required to sign off on financial reports, and relinquishment of certain executives' bonuses in case of financial restatements; and expanded financial disclosure of firms' relationships with unconsolidated entities.
On February 13, 2002, due to the instances of corporate malfeasances and accounting violations, the SEC called for changes to the stock exchanges' regulations. In June 2002, the New York Stock Exchange
announced a new governance proposal, which was approved by the SEC in November 2003. The main provisions of the final NYSE proposal include:
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
of the Enron Corporation
Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
, an American energy
Energy
In physics, energy is an indirectly observed quantity. It is often understood as the ability a physical system has to do work on other physical systems...
company based in Houston, Texas
Houston, Texas
Houston is the fourth-largest city in the United States, and the largest city in the state of Texas. According to the 2010 U.S. Census, the city had a population of 2.1 million people within an area of . Houston is the seat of Harris County and the economic center of , which is the ...
, and the dissolution of Arthur Andersen
Arthur Andersen
Arthur Andersen LLP, based in Chicago, was once one of the "Big Five" accounting firms among PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG, providing auditing, tax, and consulting services to large corporations...
, which was one of the five largest
Big Four auditors
The Big Four are the four largest international professional services networks in accountancy and professional services, which handle the vast majority of audits for publicly traded companies as well as many private companies, creating an oligopoly in auditing large companies...
audit
Audit
The general definition of an audit is an evaluation of a person, organization, system, process, enterprise, project or product. The term most commonly refers to audits in accounting, but similar concepts also exist in project management, quality management, and energy conservation.- Accounting...
and accountancy
Accountancy
Accountancy is the process of communicating financial information about a business entity to users such as shareholders and managers. The communication is generally in the form of financial statements that show in money terms the economic resources under the control of management; the art lies in...
partnership
Partnership
A partnership is an arrangement where parties agree to cooperate to advance their mutual interests.Since humans are social beings, partnerships between individuals, businesses, interest-based organizations, schools, governments, and varied combinations thereof, have always been and remain commonplace...
s in the world. In addition to being the largest bankruptcy reorganization in American history at that time, Enron was attributed as the biggest audit failure.
Enron was formed in 1985 by Kenneth Lay
Kenneth Lay
Kenneth Lee "Ken" Lay was an American businessman, best known for his role in the widely reported corruption scandal that led to the downfall of Enron Corporation. Lay and Enron became synonymous with corporate abuse and accounting fraud when the scandal broke in 2001...
after merging Houston Natural Gas
Houston Natural Gas
Houston Natural Gas Company was a gas utility headquartered in Houston, Texas. The company was acquired by InterNorth Inc. in 1985, with HNG executives taking top positions at InterNorth. Following the transaction, InterNorth was renamed Enron Corporation, and the company headquarters was moved...
and InterNorth
InterNorth
InterNorth Inc. was a very large energy company headquartered in Omaha, Nebraska, in the United States, specializing in natural gas pipelines but also a force in the plastics industry, coal and petroleum exploration and production. They operated the largest natural gas pipeline in North America...
. Several years later, when Jeffrey Skilling
Jeffrey Skilling
Jeffrey Keith "Jeff" Skilling is the former president of Enron Corporation, headquartered in Houston, Texas. In 2006 he was convicted of multiple federal felony charges relating to Enron's financial collapse, and is currently serving a 24-year, four-month prison sentence at the Federal...
was hired, he developed a staff of executives that, through the use of accounting loopholes, special purpose entities
Special purpose entity
A special purpose entity is a legal entity created to fulfill narrow, specific or temporary objectives...
, and poor financial reporting, were able to hide billions in debt from failed deals and projects. Chief Financial Officer Andrew Fastow
Andrew Fastow
Andrew Stuart Fastow was the chief financial officer of Enron Corporation that was based in Houston, Texas until the U.S. Securities and Exchange Commission opened an investigation into his and the company's conduct in 2001...
and other executives not only misled Enron's board of directors and audit committee on high-risk accounting practices, but also pressured Andersen to ignore the issues.
Shareholders lost nearly $11 billion when Enron's stock price, which hit a high of US$
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....
90 per share in mid-2000, plummeted to less than $1 by the end of November 2001. The U.S. Securities and Exchange Commission (SEC) began an investigation, and rival Houston competitor Dynegy
Dynegy
Dynegy Inc. , based in Houston, Texas, United States, is a large owner and operator of power plants and a player in the natural gas liquids and coal business...
offered to purchase the company at a fire sale
Fire sale
A fire sale is the sale of goods at extremely discounted prices, typically when the seller faces bankruptcy or other impending distress. The term may originally have been based on the sale of goods at a heavy discount due to fire damage...
price. The deal fell through, and on December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code
Bankruptcy in the United States
Bankruptcy in the United States is governed under the United States Constitution which authorizes Congress to enact "uniform Laws on the subject of Bankruptcies throughout the United States." Congress has exercised this authority several times since 1801, most recently by adopting the Bankruptcy...
. Enron's $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history until WorldCom's bankruptcy the following year.
Many executives at Enron were indicted for a variety of charges and were later sentenced to prison. Enron's auditor, Arthur Andersen, was found guilty in a United States District Court, but by the time the ruling was overturned
Arthur Andersen LLP v. United States
Arthur Andersen LLP v. United States, 544 U.S. 696 was a United States Supreme Court case in which the Court unanimously overturned accounting firm Arthur Andersen's conviction of obstruction of justice on the basis that the jury instructions did not properly portray the law Andersen was charged...
at the U.S. Supreme Court
Supreme Court of the United States
The Supreme Court of the United States is the highest court in the United States. It has ultimate appellate jurisdiction over all state and federal courts, and original jurisdiction over a small range of cases...
, the firm had lost the majority of its customers and had shut down. Employees and shareholders received limited returns in lawsuits, despite losing billions in pensions and stock prices. As a consequence of the scandal, new regulations and legislation were enacted to expand the accuracy of financial reporting for public companies. One piece of legislation, the Sarbanes-Oxley Act
Sarbanes-Oxley Act
The Sarbanes–Oxley Act of 2002 , also known as the 'Public Company Accounting Reform and Investor Protection Act' and 'Corporate and Auditing Accountability and Responsibility Act' and commonly called Sarbanes–Oxley, Sarbox or SOX, is a United States federal law enacted on July 30, 2002, which...
, expanded repercussions for destroying, altering, or fabricating records in federal investigations or for attempting to defraud shareholders. The act also increased the accountability of auditing firms to remain unbiased and independent of their clients.
Rise of Enron
Kenneth Lay
Kenneth Lee "Ken" Lay was an American businessman, best known for his role in the widely reported corruption scandal that led to the downfall of Enron Corporation. Lay and Enron became synonymous with corporate abuse and accounting fraud when the scandal broke in 2001...
merged the natural gas pipeline
Pipeline transport
Pipeline transport is the transportation of goods through a pipe. Most commonly, liquids and gases are sent, but pneumatic tubes that transport solid capsules using compressed air are also used....
companies of Houston Natural Gas
Houston Natural Gas
Houston Natural Gas Company was a gas utility headquartered in Houston, Texas. The company was acquired by InterNorth Inc. in 1985, with HNG executives taking top positions at InterNorth. Following the transaction, InterNorth was renamed Enron Corporation, and the company headquarters was moved...
and InterNorth
InterNorth
InterNorth Inc. was a very large energy company headquartered in Omaha, Nebraska, in the United States, specializing in natural gas pipelines but also a force in the plastics industry, coal and petroleum exploration and production. They operated the largest natural gas pipeline in North America...
to form Enron. In the early 1990s, he helped to initiate the selling of electricity at market prices
Energy market
Energy markets are those commodities markets that deal specifically with the trade and supply of energy. Energy market may refer to an electricity market, but can also refer to other sources of energy...
and, soon after, the United States Congress passed legislation deregulating
Deregulation
Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces.Deregulation is the removal or...
the sale of natural gas
Natural gas
Natural gas is a naturally occurring gas mixture consisting primarily of methane, typically with 0–20% higher hydrocarbons . It is found associated with other hydrocarbon fuel, in coal beds, as methane clathrates, and is an important fuel source and a major feedstock for fertilizers.Most natural...
. The resulting markets made it possible for traders such as Enron to sell energy at higher prices, thereby significantly increasing its revenue. After producers and local governments decried the resultant price volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
and pushed for increased regulation, strong lobbying
Lobbying
Lobbying is the act of attempting to influence decisions made by officials in the government, most often legislators or members of regulatory agencies. Lobbying is done by various people or groups, from private-sector individuals or corporations, fellow legislators or government officials, or...
on the part of Enron and others, was able to keep the free market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...
system in place.
As Enron rose to become the largest seller of natural gas in North America by 1992, its gas contracts trading earned earnings before interest and taxes
Earnings before interest and taxes
In accounting and finance, earnings before interest and taxes is a measure of a firm's profit that excludes interest and income tax expenses. Operating income is the difference between operating revenues and operating expenses...
of $122 million, the second largest contributor to the company's net income. The November 1999 creation of the EnronOnline trading website allowed the company to better manage its contracts trading business.
In an attempt to achieve further growth, Enron pursued a diversification strategy. The company owned and operated a variety of assets including gas pipelines, electricity plants, pulp and paper plants, water plants, and broadband services across the globe. The corporation also gained additional revenue by trading contracts for the same array of products and services it was involved in.
As a result, Enron's stock rose from the start of the 1990s until year-end 1998 by 311% percent, a significant increase over the rate of growth in the Standard & Poor 500 index
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
. The stock increased by 56% in 1999 and a further 87% in 2000, compared to a 20% increase and a 10% decline for the index during the same years. By December 31, 2000, Enron’s stock was priced at $83.13 and its market capitalization exceeded $60 billion, 70 times earnings
P/E ratio
The P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share...
and six times book value
Net asset value
Net asset value is a term used to describe the value of an entity's assets less the value of its liabilities. The term is most commonly used in relation to open-ended or mutual funds because shares of such funds registered with the U.S. Securities and Exchange Commission are redeemed at their net...
, an indication of the stock market’s high expectations about its future prospects. In addition, Enron was rated the most innovative large company in America in Fortunes Most Admired Companies survey.
Causes of downfall
Enron's nontransparent financial statementsFinancial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
did not clearly depict its operations and finances with shareholders and analysts. In addition, its complex business model
Business model
A business model describes the rationale of how an organization creates, delivers, and captures value...
and unethical practices required that the company use accounting limitations to misrepresent earnings and modify the balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
to portray a favorable depiction of its performance. According to McLean and Elkid in their book The Smartest Guys in the Room, "The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control." In an article by James Bodurtha, Jr., he argues that from 1997 until its demise, "the primary motivations for Enron's accounting and financial transactions seem to have been to keep reported income
Net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
and reported cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
up, asset values
Gross asset value
The Gross Asset Value is the sum of value of property a company owns.Besides the Net asset value, the GAV is a common KPI for property funds to measure the success of the fund manager....
inflated, and liabilities off the books
Off-balance-sheet
Off-balance sheet usually means an asset or debt or financing activity not on the company's balance sheet.Some companies may have significant amounts of off-balance sheet assets and liabilities. For example, financial institutions often offer asset management or brokerage services to their clients...
."
The combination of these issues later led to the bankruptcy of the company, and the majority of them were perpetuated by the indirect knowledge or direct actions of Lay, Jeffrey Skilling
Jeffrey Skilling
Jeffrey Keith "Jeff" Skilling is the former president of Enron Corporation, headquartered in Houston, Texas. In 2006 he was convicted of multiple federal felony charges relating to Enron's financial collapse, and is currently serving a 24-year, four-month prison sentence at the Federal...
, Andrew Fastow
Andrew Fastow
Andrew Stuart Fastow was the chief financial officer of Enron Corporation that was based in Houston, Texas until the U.S. Securities and Exchange Commission opened an investigation into his and the company's conduct in 2001...
, and other executives. Lay served as the chairman of the company in its last few years, and approved of the actions of Skilling and Fastow although he did not always inquire about the details. Skilling, constantly focused on meeting Wall Street expectations, pushed for the use of mark-to-market accounting and pressured Enron executives to find new ways to hide its debt. Fastow and other executives "...created off-balance-sheet vehicles, complex financing structures, and deals so bewildering that few people can understand them even now."
Revenue recognition
Enron and other energy suppliers earned profits by providing services such as wholesale trading and risk managementRisk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
in addition to building and maintaining electric power plants, natural gas pipelines, storage, and processing facilities. When taking on the risk of buying and selling products, merchants are allowed to report the selling price as revenues and the products' costs as cost of goods sold
Cost of goods sold
Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
. In contrast, an "agent
Agent (economics)
In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....
" provides a service to the customer, but does not take on the same risks as merchants for buying and selling. Service provider
Service provider
A service provider is an entity that provides services to other entities. Usually, this refers to a business that provides subscription or web service to other businesses or individuals. Examples of these services include Internet access, Mobile phone operators, and web application hosting...
s, when classified as agents, are able to report trading and brokerage fees as revenue, although not for the full value of the transaction.
How Fastow's Partnerships Worked (based on Enron 10-K)
Although trading firms such as Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
and Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
used the conventional "agent model" for reporting revenue (where only the trading or brokerage fee would be reported as revenue), Enron instead elected to report the entire value of each of its trades as revenue. This "merchant model" approach was considered much more aggressive in the accounting interpretation than the agent model. Enron's method of reporting inflated trading revenue was later adopted by other companies in the energy trading industry in an attempt to stay competitive with the company's large increase in revenue. Other energy companies such as Duke Energy
Duke Energy
Duke Energy , headquartered in Charlotte, North Carolina, is an energy company with assets in the United States, Canada and Latin America.-Overview:...
, Reliant Energy
Reliant Energy
RRI Energy, Inc. , based in Houston, Texas, United States, was an energy company that provided electricity to wholesale customers in the United States. The company was one of the largest independent power producers in the nation with more than 14,000 megawatts of power generation capacity across...
, and Dynegy
Dynegy
Dynegy Inc. , based in Houston, Texas, United States, is a large owner and operator of power plants and a player in the natural gas liquids and coal business...
joined Enron in the top 50 of the Fortune 500
Fortune 500
The Fortune 500 is an annual list compiled and published by Fortune magazine that ranks the top 500 U.S. closely held and public corporations as ranked by their gross revenue after adjustments made by Fortune to exclude the impact of excise taxes companies collect. The list includes publicly and...
mainly due to their adoption of the same trading revenue accounting approach as Enron.
Between 1996 to 2000, Enron's revenues increased by more than 750%, rising from $13.3 billion in 1996 to $100.8 billion in 2000. This extensive expansion of 65% per year was unprecedented in any industry, including the energy industry which typically considered growth of 2–3% per year to be respectable. For just the first nine months of 2001, Enron reported $138.7 billion in revenues, which placed the company at the sixth position on the Fortune Global 500
Fortune Global 500
The Fortune Global 500 is a ranking of the top 500 corporations worldwide as measured by revenue. The list is compiled and published annually by Fortune magazine....
.
Mark-to-market accounting
In Enron's natural gas business, the accounting had been fairly straightforward: in each time periodAccounting period
An accounting period is a period with reference to which United Kingdom corporation tax is charged. It helps dictate when tax is paid on income and gains...
, the company listed actual costs of supplying the gas and actual revenues received from selling it. However, when Skilling joined the company, he demanded that the trading business adopt mark-to-market accounting, citing that it would reflect "... true economic value." Enron became the first non-financial company to use the method to account for its complex long-term contracts. Mark-to-market accounting requires that once a long-term contract was signed, income was estimated as the present value of net future cash flows. Often, the viability of these contracts and their related costs were difficult to judge. Due to the large discrepancies of attempting to match profits and cash, investors were typically given false or misleading reports. While using the method, income from projects could be recorded, which increased financial earnings. However, in future years, the profits could not be included, so new and additional income had to be included from more projects to develop additional growth to appease investors. As one Enron competitor pointed out, "If you accelerate your income, then you have to keep doing more and more deals to show the same or rising income." Despite potential pitfalls, the U.S. Securities and Exchange Commission (SEC) approved the accounting method for Enron in its trading of natural gas futures contracts on January 30, 1992. However, Enron later expanded its use to other areas in the company to help it meet Wall Street projections.
For one contract, in July 2000, Enron and Blockbuster Video signed a 20-year agreement to introduce on-demand entertainment to various U.S. cities by year-end. After several pilot projects, Enron recognized estimated profits of more than $110 million from the deal, even though analysts questioned the technical viability and market demand of the service. When the network failed to work, Blockbuster pulled out of the contract. Enron continued to recognize future profits, even though the deal resulted in a loss.
Special purpose entities
Enron used special purpose entities—limited partnerships or companies created to fulfill a temporary or specific purpose—to fund or manage risks associated with specific assetAsset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s. The company elected to disclose minimal details on its use of special purpose entities. These shell firms
Shell (corporation)
A shell corporation is a company which serves as a vehicle for business transactions without itself having any significant assets or operations. Shell corporations are not in themselves illegal and have legitimate business purposes. However, they are a main component of the underground economy,...
were created by a sponsor, but funded by independent equity investors and debt financing. For financial reporting purposes, a series of rules dictates whether a special purpose entity is a separate entity from the sponsor. In total, by 2001, Enron had used hundreds of special purpose entities to hide its debt.
The special purpose entities were used for more than just circumventing accounting conventions. As a result of one violation, Enron's balance sheet understated its liabilities and overstated its equity
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
, and its earnings were overstated. Enron disclosed to its shareholders that it had hedged
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
downside risk in its own illiquid
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
investments using special purpose entities. However, the investors were oblivious to the fact that the special purpose entities were actually using the company's own stock and financial guarantees to finance these hedges. This setup prevented Enron from being protected from the downside risk. Notable examples of special purpose entities that Enron employed were JEDI, Chewco, Whitewing, and LJM.
JEDI and Chewco
In 1993, Enron set up a joint venture in energy investments with CalPERSCalPERS
The California Public Employees' Retirement System or CalPERS is an agency in the California executive branch that "manages pension and health benefits for more than 1.6 million California public employees, retirees, and their families"...
, the California state pension fund, called the Joint Energy Development Investments (JEDI). In 1997, Skilling, serving as Chief Operating Officer
Chief operating officer
A Chief Operating Officer or Director of Operations can be one of the highest-ranking executives in an organization and comprises part of the "C-Suite"...
(COO), asked CalPERS to join Enron in a separate investment. CalPERS was interested in the idea, but only if it could be removed as a partner in JEDI. However, Enron did not want to show any debt from taking over CalPERS' stake in JEDI on its balance sheet. Chief Financial Officer
Chief financial officer
The chief financial officer or Chief financial and operating officer is a corporate officer primarily responsible for managing the financial risks of the corporation. This officer is also responsible for financial planning and record-keeping, as well as financial reporting to higher management...
(CFO) Fastow developed the special purpose entity Chewco Investments
Chewco
Chewco Investments L. P., was a limited partnership associated with the Enron scandal, which resulted in the bankruptcy of Enron. It was named after the Star Wars character Chewbacca, because it was created to hide losses from the Joint Energy Development Investment Limited, known by its acronym...
L.P.
Limited partnership
A limited partnership is a form of partnership similar to a general partnership, except that in addition to one or more general partners , there are one or more limited partners . It is a partnership in which only one partner is required to be a general partner.The GPs are, in all major respects,...
which raised debt guaranteed by Enron and was used to acquire CalPER's joint venture stake for $383 million. Because of Fastow's organization of Chewco, JEDI's losses were kept off of Enron's balance sheet.
In fall 2001, CalPERS and Enron's arrangement was discovered, which required the discontinuation of Enron's prior accounting approach for Chewco and JEDI. This disqualification revealed that Enron's reported earnings from 1997 to mid-2001 would need to be reduced by $405 million and that the company's indebtedness would rise by $628 million.
Whitewing
The White-winged DoveWhite-winged Dove
The White-winged Dove is a dove whose native range extends from the south-western USA through Mexico, Central America, and the Caribbean. In recent years with increasing urbanization and backyard feeding, it has expanded throughout Texas and into Louisiana...
is native to Texas, and was also the name of a special purpose entity used as a financing vehicle by Enron. In December 1997, with funding of $579 million provided by Enron and $500 million by an outside investor, Whitewing Associates L.P. was formed. Two years later, the entity's arrangement was changed so that it would no longer be consolidated with Enron and be counted on the company's balance sheet. Whitewing was used to purchase Enron assets, including stakes in power plants, pipelines, stocks, and other investments. Between 1999 and 2001, Whitewing bought assets from Enron worth $2 billion, using Enron stock as collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
. Although the transactions were approved by the Enron board, the assets transfers were not true sales and should have been treated instead as loans.
LJM and Raptors
In 1999, Fastow formulated two limited partnerships: LJM Cayman. L.P. (LJM1) and LJM2 Co-Investment L.P. (LJM2), for the purpose of buying Enron's poorly performing stocks and stakes to improve its financial statements. LJM 1 and 2 were created solely to serve as the outside equity investor needed for the special purpose entities that were being used by Enron. Fastow had to go before the board of directors to receive an exemption from Enron's code of ethics (as he held the title of CFO) in order to run the companies. The two partnerships were funded with around $390 million provided by WachoviaWachovia
Wachovia was a diversified financial services company based in Charlotte, North Carolina. Before its acquisition by Wells Fargo in 2008, Wachovia was the fourth-largest bank holding company in the United States based on total assets...
, J.P. Morgan Chase, Credit Suisse First Boston
Credit Suisse First Boston
Credit Suisse First Boston was the former name of the banking firm Credit Suisse.-History:In 1978, Credit Suisse and First Boston Corporation formed a London-based 50-50 investment banking joint venture called the Financière Crédit Suisse-First Boston...
, Citigroup
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
, and other investors. Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
, which marketed the equity, also contributed $22 million to support the entities.
Enron transferred to "Raptor I-IV", four LJM-related special purpose entities named after the velociraptor
Velociraptor
Velociraptor is a genus of dromaeosaurid theropod dinosaur that existed approximately 75 to 71 million years ago during the later part of the Cretaceous Period. Two species are currently recognized, although others have been assigned in the past. The type species is V. mongoliensis; fossils...
s in Jurassic Park
Jurassic Park (film)
Jurassic Park is a 1993 American science fiction adventure film directed by Steven Spielberg. The film is based on the novel of the same name by Michael Crichton. It stars Sam Neill, Laura Dern, Jeff Goldblum, Richard Attenborough, Martin Ferrero, and Bob Peck...
, more than "$1.2 billion in assets, including millions of shares of Enron common stock
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...
and long term rights to purchase millions more shares, plus $150 million of Enron notes payable" as disclosed in the company's financial statement footnotes. The special purpose entities had been used to pay for all of this using the entities' debt instruments
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
. The footnotes also declared that the instruments' face amount totaled $1.5 billion, and the entities notional amount
Notional amount
The notional amount on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument...
of $2.1 billion had been used to enter into derivative contracts with Enron.
Enron capitalized the Raptors, and, in a manner similar to the accounting that's employed when a company issues stock at a public offering, then booked the notes payable issued as assets on its balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
while increasing the shareholders' equity for the same amount. This treatment later became an issue for Enron and its auditor Arthur Andersen
Arthur Andersen
Arthur Andersen LLP, based in Chicago, was once one of the "Big Five" accounting firms among PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG, providing auditing, tax, and consulting services to large corporations...
as removing it from the balance sheet resulted in a $1.2 billion decrease in net shareholder equity.
Eventually the derivative contracts worth $2.1 billion lost significant value. Swap
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
s were established at the point the stock price hit its high points. Over a year the value of the portfolio under the swaps fell by $1.1 billion as the stock prices dropped (the loss in value meant that the special purpose entities technically now owed Enron $1.1 billion under the contracts). Enron, which used a "fair value" accounting method, claimed a $500 million gain on the swap contracts in its 2000 annual report
Annual report
An annual report is a comprehensive report on a company's activities throughout the preceding year. Annual reports are intended to give shareholders and other interested people information about the company's activities and financial performance...
. The gain was responsible for offsetting its stock portfolio losses and was attributed to nearly a third of Enron's earnings for 2000 (before it was properly restated in 2001).
Corporate governance
Healy and Palepu write that a well-functioning capital market "creates appropriate linkages of information, incentives, and governance between managers and investors. This process is supposed to be carried out through a network of intermediaries that include assurance professionals such as external auditors; and internal governance agents such as corporate boards." On paper, Enron had a model board of directorsBoard of directors
A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. Other names include board of governors, board of managers, board of regents, board of trustees, and board of visitors...
comprising predominantly outsiders with significant ownership stakes and a talented audit committee. In its 2000 review of best corporate boards, Chief Executive included Enron among its top five boards. Even with its complex corporate governance and network of intermediaries, Enron was still able to "attract large sums of capital to fund a questionable business model, conceal its true performance through a series of accounting and financing maneuvers, and hype its stock to unsustainable levels."
Executive compensation
Although Enron's compensation and performance management system was designed to retain and reward its most valuable employees, the setup of the system contributed to a dysfunctional corporate cultureOrganizational culture
Organizational culture is defined as “A pattern of shared basic assumptions invented, discovered, or developed by a given group as it learns to cope with its problems of external adaptation and internal integration" that have worked well enough to be considered valid and therefore, to be taught to...
that became obsessed with a focus only on short-term earnings to maximize bonuses. Employees constantly looked to start high-volume deals, often disregarding the quality of cash flow or profits, in order to get a higher rating for their performance review. In addition, accounting results were recorded as soon as possible to keep up with the company's stock price. This practice helped ensure deal-makers and executives received large cash bonuses and stock options.
The company was constantly focusing on its stock price. Management was extensively compensated using stock options, similar to other U.S. companies. This setup of stock option awards caused management to create expectations of rapid growth in efforts to give the appearance of reported earnings to meet Wall Street's expectations. The stock ticker was located in lobbies, elevators, and on company computers. At budget meetings, Skilling would develop target earnings by asking "What earnings do you need to keep our stock price up?" and that number would be used, even if it was not feasible. At December 31, 2000, Enron had 96 million shares outstanding under stock option plans
Employee stock option
An employee stock option is a call option on the common stock of a company, issued as a form of non-cash compensation. Restrictions on the option attempt to align the holder's interest with those of the business shareholders. If the company's stock rises, holders of options generally experience a...
(approximately 13% of common shares outstanding). Enron's proxy statement stated that, within three years, these awards were expected to be exercised. Using Enron's January 2001 stock price of $83.13 and the directors’ beneficial ownership reported in the 2001 proxy, the value of director stock ownership was $659 million for Lay, and $174 million for Skilling.
Skilling believed that if employees were constantly cost-centered, it would hinder original thinking. As a result, extravagant spending was rampant throughout the company, especially among the executives. Employees had large expense accounts and many executives were paid sometimes twice as much as competitors. In 1998, the top 200 highest-paid employees received $193 million from salaries, bonuses, and stock. Two years later, the figure jumped to $1.4 billion.
Risk management
Before its fall, Enron was lauded for its sophisticated financial risk management tools. Risk management was crucial to Enron not only because of its regulatory environment, but also because of its business planBusiness plan
A business plan is a formal statement of a set of business goals, the reasons why they are believed attainable, and the plan for reaching those goals. It may also contain background information about the organization or team attempting to reach those goals....
. Enron established long-term fixed commitments which needed to be hedged to prepare for the inevitable fluctuation of future energy prices. Enron's bankruptcy downfall was attributed to its reckless use of derivatives and special purpose entities. By hedging its risks with special purpose entities which it owned, Enron retained the risks associated with the transactions. This setup had Enron implementing hedges with itself.
Enron's aggressive accounting practices were not hidden from the board of directors, as later learned by a Senate subcommittee. The board was informed on the rationale for using the Whitewing, LJM, and Raptor transactions, and after approving them, received status updates on the entities' operations. Although not all of Enron's widespread improper accounting practices were revealed to the board, the practices were dependent on board decisions. Even though Enron extensively relied on derivatives for its business, the company's Finance Committee and board did not have comprehensive backgrounds in derivatives to grasp what they were being told. The Senate subcommittee argued that had there been a detailed understanding of how the derivatives were organized, the board would have prevented their use.
Financial audit
Enron's auditor firm, Arthur AndersenArthur Andersen
Arthur Andersen LLP, based in Chicago, was once one of the "Big Five" accounting firms among PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG, providing auditing, tax, and consulting services to large corporations...
, was accused of applying reckless standards in its audits because of a conflict of interest
Conflict of interest
A conflict of interest occurs when an individual or organization is involved in multiple interests, one of which could possibly corrupt the motivation for an act in the other....
over the significant consulting fees generated by Enron. In 2000, Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees (this amount accounted for roughly 27% of the audit fees of public clients for Arthur Andersen's Houston office). The firms' methods were questioned as either being completed solely to receive its annual fees or for its lack of expertise in properly reviewing Enron's revenue recognition, special entities, derivatives, and other accounting practices.
Enron hired numerous Certified Public Accountant
Certified Public Accountant
Certified Public Accountant is the statutory title of qualified accountants in the United States who have passed the Uniform Certified Public Accountant Examination and have met additional state education and experience requirements for certification as a CPA...
s (CPA) as well as accountants who had worked on developing accounting rules with the Financial Accounting Standards Board
Financial Accounting Standards Board
The Financial Accounting Standards Board is a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles within the United States in the public's interest...
(FASB). The accountants looked for new ways to save the company money, including capitalizing on loopholes found in Generally Accepted Accounting Principles
Generally Accepted Accounting Principles
Generally Accepted Accounting Principles refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards...
(GAAP), the accounting industry's standards. One Enron accountant revealed "We tried to aggressively use the literature [GAAP] to our advantage. All the rules create all these opportunities. We got to where we did because we exploited that weakness."
Andersen's auditors were pressured by Enron's management to defer recognizing the charges from the special purpose entities as its credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
s became clear. Since the entities would never return a profit, accounting guidelines required that Enron should take a write-off
Write-off
The term write-off describes a reduction in recognized value. In accounting terminology, it refers to recognition of the reduced or zero value of an asset. In income tax statements, it refers to a reduction of taxable income as recognition of certain expenses required to produce the income...
, where the value of the entity was removed from the balance sheet at a loss. To pressure Andersen into meeting Enron's earnings expectations, Enron would occasionally allow accounting firms Ernst & Young
Ernst & Young
Ernst & Young is one of the largest professional services networks in the world and one of the "Big Four" accountancy firms, along with Deloitte, KPMG and PricewaterhouseCoopers ....
or PricewaterhouseCoopers
PricewaterhouseCoopers
PricewaterhouseCoopers is a global professional services firm headquartered in London, United Kingdom. It is the world's largest professional services firm measured by revenues and one of the "Big Four" accountancy firms....
to complete accounting tasks to create the illusion of hiring a new firm to replace Andersen. Although Andersen was equipped with internal controls to protect against conflicted incentives of local partners, it failed to prevent conflict of interest. In one case, Andersen's Houston office, which performed the Enron audit, was able to overrule any critical reviews of Enron's accounting decisions by Andersen's Chicago partner. In addition, after news of SEC investigations of Enron were made public, Andersen would later shred several tons of supporting documents and deleting nearly 30,000 e-mails and computer files, raising accusations of a cover-up.
Revelations concerning Andersen's overall performance led to the break-up of the firm, and to the following assessment by the Powers Committee (appointed by Enron's board to look into the firm's accounting in October 2001): "The evidence available to us suggests that Andersen did not fulfill its professional responsibilities in connection with its audits of Enron's financial statements, or its obligation to bring to the attention of Enron's Board (or the Audit and Compliance Committee) concerns about Enron's internal contracts over the related-party transactions".
Audit committee
Corporate audit committees usually meet for just a few times during the year, and their members typically have only a modest background in accounting and finance. Enron's audit committee had more expertise than many. It included:- Robert Jaedicke of Stanford UniversityStanford UniversityThe Leland Stanford Junior University, commonly referred to as Stanford University or Stanford, is a private research university on an campus located near Palo Alto, California. It is situated in the northwestern Santa Clara Valley on the San Francisco Peninsula, approximately northwest of San...
, a widely respected accounting professor and former dean of Stanford Business School; - John Mendelsohn, President of the University of Texas M.D. Anderson Cancer Center
- Paulo Pereira, former president and CEO of the State Bank of Rio de Janeiro in Brazil
- John WakehamJohn WakehamJohn Wakeham, Baron Wakeham, PC, DL is a businessman and British Conservative Party politician and the current Chancellor of Brunel University.He was a director of Enron from 1994 until its bankruptcy in 2001....
, former United Kingdom Secretary for Energy - Ronnie ChanRonnie ChanRonnie Chan Chi-chung is a Hong Kong entrepreneur. He graduated with an MBA from the University of Southern California....
, a Hong KongHong KongHong Kong is one of two Special Administrative Regions of the People's Republic of China , the other being Macau. A city-state situated on China's south coast and enclosed by the Pearl River Delta and South China Sea, it is renowned for its expansive skyline and deep natural harbour...
businessman - Wendy Gramm, former Chair of U.S. Commodity Futures Trading CommissionCommodity Futures Trading CommissionThe U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
Enron's audit committee was later criticized for its brief meetings that would cover large amounts of material. In one meeting on February 12, 2001, the committee met for an hour and a half. Enron's audit committee did not have the technical knowledge to properly question the auditors on accounting questions related to the company's special purpose entities. The committee was also unable to question the company's management due to pressures placed on the committee. The Permanent Subcommittee on Investigations of the Committee on Governmental Affairs
United States Senate Committee on Homeland Security and Governmental Affairs
The United States Senate Committee on Homeland Security and Governmental Affairs has jurisdiction over matters related to the Department of Homeland Security and other homeland security concerns, as well as the functioning of the government itself, including the National Archives, budget and...
' report accused the board members of allowing conflicts of interest to impede their duties as monitoring the company's accounting practices. When Enron fell, the audit committee's conflicts of interest were regarded with suspicion.
Other accounting issues
Enron made a habit of booking costs of cancelled projects as assets, with the rationale that no official letter had stated that the project was cancelled. This method was known as "the snowball", and although it was initially dictated that snowballs stay under $90 million, it was later extended to $200 million.In 1998, when analysts were given a tour of the Enron Energy Services
Enron Energy Services
Enron Energy Services was a business unit of Enron Corporation, whose purpose was to provide gas, electricity, and energy management directly to businesses and homes. Enron compared the service to choosing a telecommunications company to provide your house with a phone line. Consumers would be...
office, they were impressed with how the employees were working so vigorously. In reality, Skilling had moved other employees to the office from other departments (instructing them to pretend to work hard) to create the appearance that the division was bigger than it was. This ruse was used several times to fool analysts about the progress of different areas of Enron to help improve the stock price.
Timeline of downfall
In February 2001, Chief Accounting Officer Rick Causey told budget managers: "From an accounting standpoint, this will be our easiest year ever. We've got 2001 in the bag." On March 5, Bethany McLeanBethany McLean
Bethany McLean is a contributing editor to Vanity Fair magazine, and known for her work on the Enron scandal and the 2008 financial crisis...
's Fortune
Fortune (magazine)
Fortune is a global business magazine published by Time Inc. Founded by Henry Luce in 1930, the publishing business, consisting of Time, Life, Fortune, and Sports Illustrated, grew to become Time Warner. In turn, AOL grew as it acquired Time Warner in 2000 when Time Warner was the world's largest...
article Is Enron Overpriced? questioned how Enron could maintain its high stock value, which was trading at 55 times its earnings. She pointed out how analysts and investors did not know exactly how Enron was earning its income. McLean was first drawn to the company's situation after an analyst suggested she view the company's 10-K report
Form 10-K
A Form 10-K is an annual report required by the U.S. Securities and Exchange Commission , that gives a comprehensive summary of a public company's performance...
, where she found "strange transactions", "erratic cash flow", and "huge debt." She called Skilling to discuss her findings prior to publishing the article, but he brushed her off, calling her "unethical" for not properly researching the company. Fastow cited to Fortune reporters that Enron could not reveal earnings details as the company had over 1,200 trading books for assorted commodities and did "... not want anyone to know what's on those books. We don't want to tell anyone where we're making money."
In a conference call on April 17, 2001, then-Chief Executive Officer
Chief executive officer
A chief executive officer , managing director , Executive Director for non-profit organizations, or chief executive is the highest-ranking corporate officer or administrator in charge of total management of an organization...
(CEO) Skilling verbally attacked Wall Street analyst Richard Grubman, who questioned Enron's unusual accounting practice during a recorded conference call. When Grubman complained that Enron was the only company that could not release a balance sheet along with its earnings statements, Skilling replied "Well, thank you very much, we appreciate that ... asshole." This became an inside joke among many Enron employees, mocking Grubman for his perceived meddling rather than Skilling's lack of tact, with slogans such as "Ask Why, Asshole". However, Skilling's comment was met with dismay and astonishment by press and public, as he had previously brushed off criticism of Enron coolly or humorously, and many believe that this lack of restraint symbolized a downward spiral that would unravel the company's deceptive practices.
By the late 1990s Enron's stock was trading for $80–90 per share, and few seemed to concern themselves with the opacity of the company's financial disclosures. In mid-July 2001, Enron reported revenues of $50.1 billion, almost triple year-to-date, and beating analysts' estimates by 3 cents a share. Despite this, Enron's profit margin had stayed at a modest average of about 2.1%, and its share price had dropped by over 30% since the same quarter of 2000.
As time passed, a number of serious concerns confronted the company. Enron had recently faced several serious operational challenges, namely logistical difficulties in running a new broadband communications trading unit, and the losses from constructing the Dabhol Power project
Dabhol Power Company
The Dabhol Power Company was a company based in India, formed to manage and operate the Dabhol Power Plant. The Dabhol plant was built through the combined effort of Enron, GE, and Bechtel...
, a large power plant in India. There was also mounting criticism of the company for the role that its subsidiary Enron Energy Services
Enron Energy Services
Enron Energy Services was a business unit of Enron Corporation, whose purpose was to provide gas, electricity, and energy management directly to businesses and homes. Enron compared the service to choosing a telecommunications company to provide your house with a phone line. Consumers would be...
had played in the power crisis of California in 2000–2001
California electricity crisis
The California electricity crisis, also known as the Western U.S. Energy Crisis of 2000 and 2001 was a situation in which California had a shortage of electricity caused by market manipulations and illegal shutdowns of pipelines by Texas energy consortiums...
.
On August 14, Skilling announced he was resigning his position as CEO after only six months. Skilling had long served as president and COO before being promoted to CEO. Skilling cited personal reasons for leaving the company. Observers noted that in the months leading up to his exit, Skilling had sold at minimum 450,000 shares of Enron at a value of around $33 million (though he still owned over a million shares at the date of his departure). Nevertheless, Lay, who was serving as chairman at Enron, assured stunned market watchers that there would be "no change in the performance or outlook of the company going forward" from Skilling's departure. Lay announced he himself would re-assume the position of chief executive officer.
The next day, however, Skilling admitted that a very significant reason for his departure was Enron's faltering price in the stock market. The columnist Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
, writing in The New York Times, asserted that Enron was an illustration of the consequences that occur from the deregulation and commodification of things such as energy. A few days later, in a letter to the editor, Kenneth Lay defended Enron and the philosophy behind the company:
On August 15, Sherron Watkins
Sherron Watkins
Sherron Watkins was Vice President of Corporate Development at the Enron Corporation. She is considered by many to be the whistleblower who helped to uncover the Enron scandal in 2001....
, vice president for corporate development, sent an anonymous letter to Lay warning him about the company's accounting practices. One statement in the letter said "I am incredibly nervous that we will implode in a wave of accounting scandals." Watkins contacted a friend who worked for Arthur Andersen and he drafted a memo to give to the audit partners over the points she raised. On August 22, Watkins individually met with Lay and gave him a six-page letter further explaining Enron's accounting issues. Lay questioned her as to whether she had told anyone outside of the company and then vowed to have the company's law firm, Vinson & Elkins, review the issues, although she argued that using the firm would present a conflict of interest. Lay consulted with other executives, and although they wanted to fire Watkins (as Texas law did not protect company whistleblower
Whistleblower
A whistleblower is a person who tells the public or someone in authority about alleged dishonest or illegal activities occurring in a government department, a public or private organization, or a company...
s), they decided against it to prevent a lawsuit. On October 15, Vinson & Elkins announced that Enron had done nothing wrong in its accounting practices as Andersen had approved each issue.
Investors' confidence declines
By the end of August 2001, his company's stock still falling, Lay named Greg Whalley, president and COO of Enron Wholesale Services and Mark Frevert, to positions in the chairman's office. Some observers suggested that Enron's investors were in significant need of reassurance, not only because the company's business was difficult to understand (even "indecipherable") but also because it was difficult to properly describe the company in financial statements. One analyst stated "it's really hard for analysts to determine where [Enron] are making money in a given quarter and where they are losing money." Lay accepted that Enron's business was very complex, but asserted that analysts would "never get all the information they want" to satisfy their curiosity. He also explained that the complexity of the business was due largely to tax strategies and position-hedging. Lay's efforts seemed to meet with limited success; by September 9, one prominent hedge fund manager noted that "[Enron] stock is trading under a cloud." The sudden departure of Skilling combined with the opacityOpaque context
An opaque context is a linguistic context in which it is not always possible to substitute co-referential expressions salva veritate. In other words, substitution of co-referential expressions into an opaque context does not always preserve truth...
of Enron's accounting books made proper assessment difficult for Wall Street. In addition, the company admitted to repeatedly using "related-party transactions," which some feared could be too-easily used to transfer losses that might otherwise appear on Enron's own balance sheet. A particularly troubling aspect of this technique was that several of the "related-party" entities had been or were being controlled by CFO Fastow.
After the September 11, 2001 attacks
September 11, 2001 attacks
The September 11 attacks The September 11 attacks The September 11 attacks (also referred to as September 11, September 11th or 9/119/11 is pronounced "nine eleven". The slash is not part of the pronunciation...
, media attention shifted away from the company and its troubles; a little less than a month later Enron announced its intention to begin the process of shearing its lower-margin assets in favor of its core businesses of gas and electricity trading. This move included selling Portland General Electric
Portland General Electric
Portland General Electric is an electrical utility based in Portland in the U.S. state of Oregon. It distributes electricity to customers in parts of Multnomah, Clackamas, Marion, Yamhill, Washington, and Polk counties - half of the inhabitants of Oregon...
to another Oregon utility, Northwest Natural Gas, for about $1.9 billion in cash and stock, and possibly selling its 65% stake in the Dabhol project in India.
Restructuring losses and SEC investigation
Enron announced on October 16 that restatements to its financial statements for years 1997 to 2000 were necessary to correct accounting violations. The restatements for the period reduced earnings by $613 million (or 23% of reported profits during the period), increased liabilities at the end of 2000 by $628 million (6% of reported liabilities and 5.5% of reported equity), and reduced equity at the end of 2000 by $1.2 billion (10% of reported equity). Additionally, Enron asserted that the broadband unit alone was worth $35 billion, a claim also mistrusted. An analyst at Standard & Poor'sStandard & Poor's
Standard & Poor's is a United States-based financial services company. It is a division of The McGraw-Hill Companies that publishes financial research and analysis on stocks and bonds. It is well known for its stock-market indices, the US-based S&P 500, the Australian S&P/ASX 200, the Canadian...
said "I don't think anyone knows what the broadband operation is worth."
Enron's management team claimed the losses were mostly due to investment losses, along with charges such as about $180 million in money spent restructuring the company's troubled broadband trading unit. In a statement, Lay revealed, "After a thorough review of our businesses, we have decided to take these charges to clear away issues that have clouded the performance and earnings potential of our core energy businesses." Some analysts were unnerved. David Fleischer
David Fleischer
David Verge Fleischer is an American born Brazilian social scientist and professor.Fleischer is professor emeritus at the University of Brasília, having taught there since 1972...
at Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
, an analyst called previously 'one of the company's strongest supporters' asserted that the Enron management "... lost credibility and have to reprove themselves. They need to convince investors these earnings are real, that the company is for real and that growth will be realized."
Fastow disclosed to Enron's board of directors
Board of directors
A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. Other names include board of governors, board of managers, board of regents, board of trustees, and board of visitors...
on October 22 that he earned $30 million from compensation arrangements when managing the LJM limited partnerships. That day, the share price of Enron fell to $20.65, down $5.40 in one day, following the announcement by the SEC that it was investigating several suspicious deals struck by Enron, characterizing them as "some of the most opaque transactions with insiders ever seen". Attempting to explain the billion-dollar charge and calm investors, Enron's disclosures spoke of "share settled costless collar arrangements," "derivative instruments which eliminated the contingent nature of existing restricted forward contract
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
s," and strategies that served "to hedge certain merchant investments and other assets." Such puzzling phraseology left many analysts feeling ignorant about just how Enron ran its business. Regarding the SEC investigation, chairman and CEO Lay said, "We will cooperate fully with the S.E.C. and look forward to the opportunity to put any concern about these transactions to rest."
Liquidity concerns
Concerns about Enron's liquidity prompted Lay to participate in a conference callConference call
A conference call is a telephone call in which the calling party wishes to have more than one called party listen in to the audio portion of the call. The conference calls may be designed to allow the called party to participate during the call, or the call may be set up so that the called party...
on October 23, in which he attempted to reassure investors that the company's cash resources were ample and no further "one-time charges" loomed. Secondly, Lay adamantly insisted there were no improprieties regarding Enron's transactions with partnerships run by Fastow and emphasized his support for the CFO. David Fleischer, the analyst at Goldman, was again skeptical, telling Lay and Fastow, "There is an appearance that you are hiding something." Nevertheless, Fleischer persisted in recommending the stock, arguing that he didn't "think accountants and auditors would have allowed total shenanigans." Lay also attempted to reassure the conferees by stressing that all of Enron's financial and accounting maneuvers had been scrutinized by their auditor, Arthur Andersen. After several questioners pressed the issue, Lay stated Enron management would "look into providing" more detailed statements for the end of better understanding the company's relationship with the special entities as those run by Fastow.
Two days later, on October 25, despite his reassurances days earlier, Lay removed Fastow from his position, citing "In my continued discussions with the financial community, it became clear to me that restoring investor confidence would require us to replace Andy as CFO." However, with Skilling and Fastow now both departed, some analysts feared that shedding light on the company's practices would be made all the more difficult. Enron's stock was now trading at $16.41, having lost half its value in a little over a week.
On October 27 the company began buying back all its commercial paper
Commercial paper
In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1 to 270 days. Commercial Paper is a money-market security issued by large banks and corporations to get money to meet short term debt obligations , and is only backed by an issuing bank or...
, valued at around $3.3 billion, in an effort to calm investor fears about Enron's supply of cash. Enron financed the re-purchase by depleting its lines of credit
Line of credit
A line of credit is any credit source extended to a government, business or individual by a bank or other financial institution. A line of credit may take several forms, such as overdraft protection, demand loan, special purpose, export packing credit, term loan, discounting, purchase of...
at several banks. While the company's debt rating was still considered investment-grade, its bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
were trading at levels slightly below, making future sales problematic.
As the month came to a close, serious concerns were being raised by some observers regarding Enron's possible manipulation of accepted accounting rules; however, analysis was claimed to be impossible based on the incomplete information provided by Enron. Industry analysts openly feared that Enron was the new Long-Term Capital Management
Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
, the hedge fund whose collapse in 1998 threatened systemic failure in the international financial markets. Enron's tremendous presence worried some about the consequences of the company's possible collapse. Enron executives were tight-lipped, accepting questions in written form only.
Credit rating downgrade
The central short-term danger to Enron's survival at the end of October 2001 seemed to be its credit rating. It was reported at the time that Moody'sMoody's
Moody's Corporation is the holding company for Moody's Analytics and Moody's Investors Service, a credit rating agency which performs international financial research and analysis on commercial and government entities. The company also ranks the credit-worthiness of borrowers using a standardized...
and Fitch
Fitch Ratings
The Fitch Group is a majority-owned subsidiary of FIMALAC, headquartered in Paris. Fitch Ratings, Fitch Solutions and Algorithmics, are part of the Fitch Group....
, two of the three biggest credit-rating agencies, had slated Enron for review for possible downgrade. Such a downgrade would force Enron to issue millions of shares of stock to cover loans it had guaranteed, a move that would bring down the value of existing stock further. Additionally, all manner of companies began reviewing their existing contracts with Enron, especially in the long term, in the event that Enron's rating were lowered below investment grade, a possible hindrance in future transactions.
Analysts and observers continued their chorus of complaints regarding Enron's difficulty or impossibility of properly assessing a company whose financial statements were so mysterious. Some feared that no one at Enron apart from Skilling and Fastow could completely explain years of mysterious transactions. "You're getting way over my head," said Lay in late August 2001 in response to detailed questions about Enron's business, a reaction that worried analysts.
On October 29, responding to growing concerns that Enron might have insufficient cash on hand, news spread that Enron was seeking a further $1–2 billion in financing from banks. The next day, as feared, Moody's lowered Enron's credit rating from Baa1 to Baa2, two levels above junk status. Standard & Poor's also lowered Enron's rating to BBB+, the equivalent of Moody's rating. Moody's also warned that it would downgrade Enron's commercial paper rating, the consequence of which would likely prevent the company from finding the further financing it sought to keep solvent.
November began with the disclosure that the SEC was now pursuing a formal investigation, prompted by questions related to Enron's dealings with "related parties". Enron's board also announced that it would commission a special committee to investigate the transactions, headed by William C. Powers
William C. Powers
William Charles Powers Jr. is the 28th president of The University of Texas at Austin, a position he has held since February 1, 2006....
, the dean of the University of Texas law school. The next day, an editorial in The New York Times called for an "aggressive" investigation into the matter. Enron was able to secure an additional $1 billion in financing from cross-town rival Dynegy
Dynegy
Dynegy Inc. , based in Houston, Texas, United States, is a large owner and operator of power plants and a player in the natural gas liquids and coal business...
on November 2, but the news was not universally admired in that the debt was secured by assets from the company's valuable Northern Natural Gas and Transwestern Pipeline
Transwestern Pipeline
Transwestern Pipeline Company, LLC owns and operates a natural gas transmission system that provides access to natural gas supplies in the San Juan and Rocky Mountain Basins in northwest New Mexico, southwest Colorado, the Texas-Oklahoma Panhandle, and the Permian Basin region of West Texas and...
.
Proposed buyout by Dynegy
Sources claimed that Enron was planning to explain its business practices more fully within the coming days, as a confidence-building gesture. Enron's stock was now trading at around $7, as investors worried that the company would not be able to find a buyer.After it received a wide spectrum of rejections, Enron management apparently found a buyer when the board of Dynegy, another energy trader based in Houston, voted late at night on November 7 to acquire Enron at a fire-sale price of about $8 billion in stock. Chevron Texaco
Chevron Corporation
Chevron Corporation is an American multinational energy corporation headquartered in San Ramon, California, United States and active in more than 180 countries. It is engaged in every aspect of the oil, gas, and geothermal energy industries, including exploration and production; refining,...
, which at the time owned about a quarter of Dynegy, agreed to provide Enron with $2.5 billion in cash, specifically $1 billion up front and the rest when the deal was completed. Dynegy would also be required to assume nearly $13 billion of debt, plus any other debt hitherto occluded by the Enron management's secretive business practices, possibly as much as $10 billion in "hidden" debt. Dynegy and Enron confirmed their deal on November 8, 2001.
Commentators remarked on the different corporate cultures between Dynegy and Enron, and on the "straight-talking" personality of the CEO of Dynegy, Charles Watson. Some wondered if Enron's troubles had not simply been the result of innocent accounting errors. By November, Enron was asserting that the billion-plus "one-time charges" disclosed in October should in reality have been $200 million, with the rest of the amount simply corrections of dormant accounting mistakes. Many feared other "mistakes" and restatements might yet be revealed.
Another major correction of Enron's earnings was announced on November 9, with a reduction of $591 million over the stated revenue of years 1997–2000. The charges were said to come largely from two special purpose partnerships (JEDI and Chewco). The corrections resulted in the virtual elimination of profit for fiscal year 1997, with significant reductions for the other years. Despite this disclosure, Dynegy declared it still intended to purchase Enron. Both companies were said to be anxious to receive an official assessment of the proposed sale from Moody's and S&P presumably to understand the effect the completion of any buyout transaction would have on Dynegy and Enron's credit rating. In addition, concerns were raised regarding antitrust regulatory hurdles leading to possible divestiture, along with what to some observers were the radically different corporate cultures of Enron and Dynegy.
Both companies pushed aggressively for the deal, and some observers were hopeful; Watson was praised for his vision in attempting to create the biggest presence on the energy market. At the time, Watson said "We feel [Enron] is a very solid company with plenty of capacity to withstand whatever happens the next few months." One analyst called the deal "a whopper [...] a very good deal financially, certainly should be a good deal strategically, and provides some immediate balance-sheet backstop for Enron."
Credit issues were becoming more critical, however. Around the time the buyout was made public, Moody's and S&P both lowered Enron's rating to just one notch above junk status. Were the company's rating to fall below investment-grade, its ability to trade would be severely limited if there was a reduction or elimination of its credit lines with competitors. In a conference call, S&P affirmed that, were Enron not to be taken over, S&P would cut its rating to low BB or high B, ratings noted as being within junk status. In addition, many traders had limited their involvement with Enron, or stopped doing business altogether, fearing more bad news. Watson again attempted to re-assure, attesting at a presentation to investors that there was "nothing wrong with Enron's business". He also acknowledged that remunerative steps (in the form of more stock options) would have to be taken to redress the animosity of many Enron employees for management after it was revealed that Lay and other top officials had sold hundreds of millions of dollars worth of stock in the months leading up to the crisis. The situation was not helped by the disclosure that Lay, his "reputation in tatters", stood to receive a payment of $60 million as a change-of-control fee subsequent to the Dynegy acquisition, while many Enron employees had seen their retirement accounts, which were largely based on Enron stock, decimated as the price fell 90% in a year. An official at a company owned by Enron stated "We had some married couples who both worked who lost as much as $800,000 or $900,000. It pretty much wiped out every employee's savings plan."
Watson assured investors that the true nature of Enron's business had been made clear to him: "We have comfort there is not another shoe to drop. If there is no shoe, this is a phenomenally good transaction." Watson further asserted that Enron's energy trading part alone was worth the price Dynegy was paying for the whole company.
By mid-November, Enron announced it was planning to sell about $8 billion worth of underperforming assets, along with a general plan to reduce its scale for the sake of financial stability. On November 19 Enron disclosed to the public further evidence of its critical state of affairs. Most pressingly that the company was facing debt repayment obligations in the range of $9 billion by the end of 2002. Such debts were "vastly in excess" of its available cash. Also, the success of measures to preserve its solvency were not guaranteed, specifically as regarded asset sales and debt refinancing. In a statement, Enron revealed "An adverse outcome with respect to any of these matters would likely have a material adverse impact on Enron's ability to continue as a going concern."
Two days later, on November 21, Wall Street expressed serious doubts that Dynegy would proceed with its deal at all, or would seek to radically renegotiate. Furthermore Enron revealed in a 10-Q filing
Form 10-Q
Form 10-Q, also known as a 10-Q or 10Q is a quarterly report designed to give a status of how a business is doing after three months of operation. These reports generally compare last quarter to the current quarter and last years quarter to this years quarter. The SEC put this form in place to...
that almost all the money it had recently borrowed for purposes including buying its commercial paper, or about $5 billion, had been exhausted in just 50 days. Analysts were unnerved at the revelation, especially since Dynegy was reported to also have been unaware of Enron's rate of cash use. In order to walk away from the proposed buyout, Dynegy would need to legally demonstrate a "material change" in the circumstances of the transaction; as late as November 22, sources close to Dynegy were skeptical that the latest revelations constituted sufficient grounds.
The SEC announced it had filed civil fraud complaints against Andersen. A few days later, sources claimed Enron and Dynegy were renegotiating the terms of their arrangement. Dynegy now demanded Enron agree to be bought for $4 billion rather than the previous $8 billion. Observers were reporting difficulties in ascertaining whether or which of Enron's operations, if any, were profitable. Reports described an en masse shift of business to Enron's competitors for the sake of risk exposure reduction.
Bankruptcy
Systemic consequences were felt, as Enron's creditors and other energy trading companies suffered the loss of several percentage points. Some analysts felt Enron's failure highlighted the risks of the post–September 11 economy, and encouraged traders to lock in profits where they could. The question now became how to determine the total exposure of the markets and other traders to Enron's failure. Early figures put the number at $18.7 billion. One adviser stated, "We don't really know who is out there exposed to Enron's credit. I'm telling my clients to prepare for the worst."
Enron was estimated to have about $23 billion in liabilities from both debt outstanding and guaranteed loans. Citigroup
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
and JP Morgan Chase in particular appeared to have significant amounts to lose with Enron's fall. Additionally, many of Enron's major assets were pledged to lenders in order to secure loans, throwing into doubt what if anything unsecured creditors and eventually stockholders might receive in bankruptcy proceedings.
Enron's European operations filed for bankruptcy on November 30, 2001, and it sought Chapter 11 protection two days later on December 2. It was the largest bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
in U.S. history (before being surpassed by WorldCom's bankruptcy the following year), and resulted in 4,000 lost jobs. The day that Enron filed for bankruptcy, the employees were told to pack up their belongings and were given 30 minutes to vacate the building. Nearly 62% of 15,000 employees' savings plans relied on Enron stock that was purchased at $83 in early 2001 and was now practically worthless.
On January 17, 2002 Enron fired Arthur Andersen as its auditor, citing its accounting advice and the destruction of documents. Andersen countered that it had already severed ties with the company when Enron entered bankruptcy.
Enron
Fastow and his wife, Lea, both pleaded guilty to charges against them. Fastow was initially charged with 98 counts of fraud, money launderingMoney laundering
Money laundering is the process of disguising illegal sources of money so that it looks like it came from legal sources. The methods by which money may be laundered are varied and can range in sophistication. Many regulatory and governmental authorities quote estimates each year for the amount...
, insider trading
Insider trading
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
, and conspiracy, among other crimes. Fastow pleaded guilty to two charges of conspiracy and was sentenced to ten years with no parole in a plea bargain to testify against Lay, Skilling, and Causey. Lea was indicted on six felony counts, but prosecutors later dropped them in favor of a single misdemeanor tax charge. Lea was sentenced to one year for helping her husband hide income from the government.
Lay and Skilling went on trial for their part in the Enron scandal in January 2006. The 53-count, 65-page indictment
Indictment
An indictment , in the common-law legal system, is a formal accusation that a person has committed a crime. In jurisdictions that maintain the concept of felonies, the serious criminal offence is a felony; jurisdictions that lack the concept of felonies often use that of an indictable offence—an...
covers a broad range of financial crimes, including bank fraud, making false statements to banks and auditors, securities fraud, wire fraud, money laundering, conspiracy, and insider trading. District Judge
United States federal judge
In the United States, the title of federal judge usually means a judge appointed by the President of the United States and confirmed by the United States Senate in accordance with Article II of the United States Constitution....
Sim Lake had previously denied motions by the defendants to hold separate trials and to move the case out of Houston, where the defendants argued the negative publicity surrounding Enron's demise would make it impossible to get a fair trial. On May 25, 2006, the jury in the Lay and Skilling trial returned its verdicts. Skilling was convicted of 19 of 28 counts of securities fraud and wire fraud and acquitted on the remaining nine, including charges of insider trading
Insider trading
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
. He was sentenced to 24 years and 4 months in prison.
Lay pleaded not guilty to the eleven criminal charges, and claimed that he was misled by those around him. He attributed the main cause for the company's fall to Fastow. Lay was convicted of all six counts of securities and wire fraud for which he had been tried, and he faced a total sentence of up to 45 years in prison. However, before sentencing was scheduled, Lay died on July 5, 2006. At the time of his death, the SEC had been seeking more than $90 million from Lay in addition to civil fines. The case surrounding Lay's wife, Linda, is a difficult one. She sold roughly 500,000 shares of Enron ten minutes to thirty minutes before the information that Enron was collapsing went public on November 28, 2001. Linda was never charged with any of the events related to Enron.
Although Michael Kopper worked at Enron for over seven years, Lay did not know of Kopper even after the company's bankruptcy. Kopper was able to keep his name anonymous in the entire affair, as the spotlight remained on Fastow. Kopper was the first Enron executive to plead guilty. Chief Accounting Officer Rick Causey was indicted with six felony charges for disguising Enron's financial shape during his tenure. After pleading not guilty, he later switched to guilty and was sentenced to seven years in prison.
All told, sixteen people pleaded guilty for crimes committed at the company, and five others, including four former Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
employees, were found guilty. Eight former Enron executives testified—the star witness being Fastow—against Lay and Skilling, his former bosses. Another was Kenneth Rice, the former chief of Enron Corp.'s high-speed Internet unit, who cooperated and whose testimony helped convict Skilling and Lay. In June 2007, he received a 27-month sentence.
Arthur Andersen
Arthur Andersen was charged with and found guilty of obstruction of justiceObstruction of justice
The crime of obstruction of justice, in United States jurisdictions, refers to the crime of interfering with the work of police, investigators, regulatory agencies, prosecutors, or other officials...
for shredding the thousands of documents and deleting e-mails and company files that tied the firm to its audit of Enron. Although only a small number of Arthur Andersen's employees were involved with the scandal, the firm was effectively put out of business; the SEC is not allowed to accept audits from convicted felons. The firm surrendered its CPA license on August 31, 2002, and 85,000 employees lost their jobs. The conviction was later overturned
Arthur Andersen LLP v. United States
Arthur Andersen LLP v. United States, 544 U.S. 696 was a United States Supreme Court case in which the Court unanimously overturned accounting firm Arthur Andersen's conviction of obstruction of justice on the basis that the jury instructions did not properly portray the law Andersen was charged...
by the U.S. Supreme Court
Supreme Court of the United States
The Supreme Court of the United States is the highest court in the United States. It has ultimate appellate jurisdiction over all state and federal courts, and original jurisdiction over a small range of cases...
due to the jury not being properly instructed
Jury instructions
Jury instructions are the set of legal rules that jurors should follow when the jury is deciding a civil or criminal case. Jury instructions are given to the jury by the jury instructor, who usually reads them aloud to the jury...
on the charge against Andersen. The Supreme Court ruling theoretically left Andersen free to resume operations. However, the damage to the Andersen name has been so great that it has not returned as a viable business even on a limited scale.
NatWest Three
Giles Darby, David Bermingham, and Gary Mulgrew worked for Greenwich NatWestNational Westminster Bank
National Westminster Bank Plc, commonly known as NatWest, is the largest retail and commercial bank in the United Kingdom and has been part of The Royal Bank of Scotland Group Plc since 2000. The Royal Bank of Scotland Group is ranked as the second largest bank in the world by assets...
. The three British men had worked with Fastow on a special purpose entity he had started called Swap Sub. When Fastow was being investigated by the SEC, the three men met with the British Financial Services Authority
Financial Services Authority
The Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...
(FSA) in November 2001 to discuss their interactions with Fastow. In June 2002, the U.S. issued warrants for their arrest on seven counts of wire fraud, and they were then extradited. On July 12, a potential Enron witness scheduled to be extradited to the U.S., Neil Coulbeck
Neil Coulbeck
Neil Coulbeck was a banker with the Royal Bank of Scotland .Coulbeck was Head of Financial Markets for North America with RBS until June 2001, when he returned to London as Head of Group Treasury. He had been questioned by the FBI in relation to the collapse of Enron, which involved the RBS...
, was found dead in a park in north-east London. The U.S. case alleged that Coulbeck and others conspired with Fastow. In a plea bargain in November 2007, the trio plead guilty to one count of wire fraud while the other six counts were dropped. Darby, Bermingham, and Mulgrew were each sentenced to 37 months in prison. In August 2010, Bermingham and Mulgrew retracted their confessions.
Employees and shareholders
More than 20,000 of Enron's former employees in May 2004 won a suit of $85 million for compensation of $2 billion that was lost from their pensions. From the settlement, the employees each received about $3,100. The following year, investors received another settlement from several banks of $4.2 billion. In September 2008, a $7.2-billion settlement from a $40-billion lawsuit, was reached on behalf of the shareholders. The settlement was distributed among the lead plaintiff, University of California
University of California
The University of California is a public university system in the U.S. state of California. Under the California Master Plan for Higher Education, the University of California is a part of the state's three-tier public higher education system, which also includes the California State University...
(UC), and 1.5 million individuals and groups. UC's law firm Coughlin Stoia Geller Rudman and Robbins
Coughlin Stoia Geller Rudman and Robbins
Robbins, Geller Rudman & Dowd LLP is a law firm in San Diego, California. The firm was formed in May 2004 when Milberg Weiss Bershad Hynes & Lerach split with the New York office, becoming Milberg Weiss Bershad & Schulman....
, received $688 million in fees, the highest in a U.S. securities fraud case. At the distribution, UC announced in a press release "We are extremely pleased to be returning these funds to the members of the class. Getting here has required a long, challenging effort, but the results for Enron investors are unprecedented."
Sarbanes-Oxley Act
Between December 2001 and April 2002, the Senate Committee on Banking, Housing, and Urban AffairsUnited States Senate Committee on Banking, Housing, and Urban Affairs
The United States Senate Committee on Banking, Housing, and Urban Affairs has jurisdiction over matters related to: banks and banking, price controls, deposit insurance, export promotion and controls, federal monetary policy, financial aid to commerce and industry, issuance of redemption of notes,...
and the House Committee on Financial Services
United States House Committee on Financial Services
The United States House Committee on Financial Services is the committee of the United States House of Representatives that oversees the entire financial services industry, including the securities, insurance, banking, and housing industries...
held multiple hearings about the collapse of Enron and related accounting and investor protection issues. These hearings and the corporate scandals that followed Enron led to the passage of the Sarbanes-Oxley Act on July 30, 2002. The Act is nearly "a mirror image of Enron: the company's perceived corporate governance failings are matched virtually point for point in the principal provisions of the Act."
The main provisions of the Sarbanes-Oxley Act included the establishment of the Public Company Accounting Oversight Board
Public Company Accounting Oversight Board
The Public Company Accounting Oversight Board is a private-sector, non-profit corporation created by the Sarbanes–Oxley Act, a 2002 United States federal law, to oversee the auditors of public companies. Its stated purpose is to 'protect the interests of investors and further the public interest...
to develop standards for the preparation of audit reports; the restriction of public accounting firms from providing any non-auditing services when auditing; provisions for the independence of audit committee members, executives being required to sign off on financial reports, and relinquishment of certain executives' bonuses in case of financial restatements; and expanded financial disclosure of firms' relationships with unconsolidated entities.
On February 13, 2002, due to the instances of corporate malfeasances and accounting violations, the SEC called for changes to the stock exchanges' regulations. In June 2002, the New York Stock Exchange
New York Stock Exchange
The New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...
announced a new governance proposal, which was approved by the SEC in November 2003. The main provisions of the final NYSE proposal include:
- All firms must have a majority of independent directors.
- Independent directors must comply with an elaborate definition of independent directors.
- The compensation committee, nominating committee, and audit committee shall consist of independent directors.
- All audit committee members should be financially literate. In addition, at least one member of the audit committee is required to have accounting or related financial management expertise.
- In addition to its regular sessions, the board should hold additional sessions without management.
See also
- The Crooked E: The Unshredded Truth About EnronThe Crooked E: The Unshredded Truth About EnronThe Crooked E: The Unshredded Truth About Enron is a television movie aired by CBS in January 2003, which was based on the book Anatomy of Greed by Brian Cruver...
– television film about the rise and fall of Enron - Enron: The Smartest Guys in the RoomEnron: The Smartest Guys in the RoomEnron: The Smartest Guys in the Room is a 2005 documentary film based on the best-selling 2003 book of the same name by Fortune reporters Bethany McLean and Peter Elkind, a study of one of the largest business scandals in American history...
– documentary based on a book about the scandal - ENRONENRON (play)ENRON is a 2009 play by the British playwright Lucy Prebble, based on the Enron scandal.-Productions:ENRON premiered at the Chichester Festival Theatre , before London transfers to the Jerwood Downstairs at the Royal Court Theatre from 17 September to 7 November 2009 and then the Noel Coward...
– 2009 play by British playwright Lucy PrebbleLucy PrebbleLucy Prebble is a British playwright. She is the author of the plays The Sugar Syndrome and ENRON and the television series Secret Diary of a Call Girl.-Biography:...
about the scandal - Fun with Dick and JaneFun with Dick and Jane (2005 film)Fun with Dick and Jane is a 2005 remake of the 1977 American comedy film of the same name, directed by Dean Parisot and written by Judd Apatow and Nicholas Stoller. It stars Jim Carrey and Téa Leoni as Dick and Jane Harper, an upper-middle-class couple who resort to robbery after the company for...
– comedy film parodying 2000s corporate scandals, including a reference to the scandal - Arthur Andersen LLP v. United StatesArthur Andersen LLP v. United StatesArthur Andersen LLP v. United States, 544 U.S. 696 was a United States Supreme Court case in which the Court unanimously overturned accounting firm Arthur Andersen's conviction of obstruction of justice on the basis that the jury instructions did not properly portray the law Andersen was charged...
– conviction in United States District Court subsequently overturned by United States Supreme Court - The Enron CorpusEnron CorpusThe Enron Corpus is a large database of over 600,000 emails generated by 158 employees of the Enron Corporation and acquired by the Federal Energy Regulatory Commission during its investigation after the company's collapse. A copy of the database was subsequently purchased for $10,000 by Andrew...
– a database of over 500,000 emails between Enron executives, made public and used extensively in social networking research