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Enron Scandal: The Fall of a Wall Street Darling By Investopedia | Updated January 3, 2018 — 11:34 AM EST Loading the player... The story of Enron Corp. is the story of a company that reached dramatic heights, only to face a dizzying fall. Its collapse affected thousands of employees and shook Wall Street to its core. At Enron's peak, its shares were worth $90.75; when it declared bankruptcy on December 2, 2001, they were trading at $0.26. To this day, many wonder how such a powerful business, at the time one of the laregest companies in the U.S, disintegrated almost overnight and how it managed to fool the regulators with fake holdings and off-the-books accounting for so long.

"America's Most Innovative Company" Enron was formed in 1985, following a merger between Houston Natural Gas Co. and Omaha-based InterNorth Inc. Following the merger, Kenneth Lay, who had been the chief executive officer (CEO) of Houston Natural Gas, became Enron's CEO and chairman and quickly rebranded Enron into an energy trader and supplier. Deregulation of the energy markets allowed companies to place bets on future prices, and Enron was poised to take advantage. The era's regulatory environment also allowed Enron to flourish. At the end of the 1990s, the dot-com bubble was in full swing, and the Nasdaq hit 5,000. Revolutionary internet stocks were being valued at preposterous levels and consequently, most investors

and regulators simply accepted spiking share prices as the new normal. Enron participated by creating Enron Online (EOL) in October 1999, an electronic trading website that focused on commodities. Enron was the counterparty to every transaction on EOL; it was either the buyer or the seller. To entice participants and trading partners, Enron offered up its reputation, credit, and expertise in the energy sector. Enron was praised for its expansions and ambitious projects, and named "America's Most Innovative Company" by Fortune for six consecutive years between 1996 and 2001. By mid-2000, EOL was executing nearly $350 billion in trades. When the dot-com bubble began to burst, Enron decided to build high-speed broadband telecom networks. Hundreds of millions of dollars were spent on this project, but the company ended up realizing almost no return. When the recession hit in 2000, Enron had significant exposure to the most volatile parts of the market. As a result, many trusting investors and creditors found themselves on the losing end of a vanishing market cap.

The Collapse of a Wall Street Darling By the fall of 2000, Enron was starting to crumble under its own weight. CEO Jeffrey Skilling had a way of hiding the financial losses of the trading business and other operations of the company; it was called mark-to-market accounting. This is a technique used where you measure the value of a security based on its current market value, instead of its book value. This can work well when trading securities, but it can be disastrous for actual businesses.

In Enron's case, the company would build an asset, such as a power plant, and immediately claim the projected profit on its books, even though it hadn't made one dime from it. If the revenue from the power plant was less than the projected amount, instead of taking the loss, the company would then transfer the asset to an off-the-books corporation, where the loss would go unreported. This type of accounting enabled Enron to write off unnprofitable activities without hurting its bottom line. The mark-to-market practice led to schemes that were designed to hide the losses and make the company appear to be more profitable than it really was. To cope with the mounting liabilities, Andrew Fastow, a rising star who was promoted to CFO in 1998, came up with a deliberate plan to make the company appear to be in sound financial shape, despite the fact that many of its subsidiaries were losing money.

How Did Enron Use SPVs to Hide its Debt? Fastow and others at Enron orchestrated a scheme to use offbalance-sheet special purpose vehicles (SPVs), also know as special purposes entities (SPEs) to hide its mountains of debt and toxic assets from investors and creditors. The primary aim of these SPVs was to hide accounting realities, rather than operating results. The standard Enron-to-SPV transaction would go like this: Enron would transfer some of its rapidly rising stock to the SPV in exchange for cash or a note. The SPV would subsequently use the stock to hedge an asset listed on Enron's balance sheet. In turn, Enron would guarantee the SPV's value to reduce apparent counterparty risk. Although their aim was to hide accounting realities, the SPVs weren't illegal, as such. But they were different from standard debt securitization in several significant – and potentially disastrous – ways. One major difference was that the SPVs were capitalized entirely with Enron stock. This directly compromised the ability of the SPVs to hedge if Enron's share prices fell. Just as dangerous was the second significant difference: Enron's failure to disclose conflicts of interest. Enron disclosed the SPVs' existence to the investing public—although it's certainly likely that few people understood them—but it failed to adequately disclose the non-arm's length deals between the company and the SPVs. Enron believed that its stock price would keep appreciating — a belief similar to that embodied by Long-Term Capital Management, a large hedge fund, before its collapse in 1998.

Eventually, Enron's stock declined. The values of the SPVs also fell, forcing Enron's guarantees to take effect.

Arthur Andersen and Enron: Risky Business In addition to Andrew Fastow, a major player in the Enron scandal was Enron's accounting firm Arthur Andersen LLP and partner David B. Duncan, who oversaw Enron's accounts. As one of the five largest accounting firms in the United States at the time, Andersen had a reputation for high standards and quality risk management. However, despite Enron's poor accounting practices, Arthur Andersen offered its stamp of approval, signing off on the corporate reports for years – which was enough for investors and regulators alike. This game couldn't go on forever, however, and by April 2001, many analysts started to question Enron's earnings and their transparency.

The Shock Felt Around Wall Street By the summer of 2001, Enron was in a free fall. CEO Ken Lay had retired in February, turning over the position to Jeff Skilling; that August, Skilling resigned as CEO for "personal reasons." Around the same time, analysts began to downgrade their rating for Enron's stock, and the stock descended to a 52-week low of $39.95. By Oct.16, the company reported its first quarterly loss and closed its "Raptor" SPV so that it would not have to distribute 58 million shares of stock, which would further reduce earnings. This action caught the attention of the SEC. A few days later, Enron changed pension plan administrators, essentially forbidding employees from selling their shares, for at least 30 days. Shortly after, the SEC announced it was

investigating Enron and the SPVs created by Fastow. Fastow was fired from the company that day. Also, the company restated earnings going back to 1997. Enron had losses of $591 million and had $628 million in debt by the end of 2000. The final blow was dealt when Dynegy (NYSE: DYN ), a company that had previously announced would merge with the Enron, backed out of the deal on Nov. 28. By Dec. 2, 2001, Enron had filed for bankruptcy. Once Enron's Plan of Reorganization was approved by the U.S. Bankruptcy Court, the new board of directors changed Enron's name to Enron Creditors Recovery Corp. (ECRC). The company's new sole mission was "to reorganize and liquidate certain of the operations and assets of the 'pre-bankruptcy' Enron for the benefit of creditors." The company paid its creditors more than $21.7 billion from 2004-2011. Its last payout was in May 2011.

Criminal Charges Arthur Andersen was one of the first casualties of Enron's prolific demise. In June 2002, the firm was found guilty of obstructing justice for shredding Enron's financial documents to conceal them from the SEC. The conviction was overturned later, on appeal; however, the firm was deeply disgraced by the scandal, and dwindled into a holding company. A group of former partners bought the name in 2014, creating a firm named Andersen Global. Several of Enron's execs were charged with a slew of charges, including conspiracy, insider trading, and securities fraud. Enron's founder and former CEO Kenneth Lay was convicted of six counts of fraud and conspiracy and four counts of bank fraud. Prior to sentencing, though, he died of a heart attack in Colorado. Enron's former star CFO Andrew Fastow plead guilty to two counts of wire fraud and securities fraud for facilitating Enron's corrupt business practices. He ultimately cut a deal for

cooperating with federal authorities and served a four-year sentence, which ended in 2011. Ultimately, though, former Enron CEO Jeffrey Skilling received the harshest sentence of anyone involved in the Enron scandal. In 2006, Skilling was convicted of conspiracy, fraud, and insider trading. Skilling originally received a 24-year sentence, but in 2013 it was reduced by 10 years. As a part of the new deal, Skilling was required to give $42 million to the victims of the Enron fraud and to cease challenging his conviction. Skilling remains in prison and is scheduled for release on Feb. 21, 2028.

New Regulations As a Result of the Enron Scandal Enron's collapse and the financial havoc it wreaked on its shareholders and employees led to new regulations and legislation to promote the accuracy of financial reporting for publicly held companies. In July of 2002, President George W. Bush signed into law the Sarbanes-Oxley Act. The Act heightened the consequences for destroying, altering or fabricating financial statements, and for trying to defraud shareholders. (For more on the 2002 Act, read: How The Sarbanes-Oxley Act Era Affected IPOs.) The Enron scandal resulted in other new compliance measures. Additionally, the Financial Accounting Standards Board (FASB) substantially raised its levels of ethical conduct. Moreover, company's boards of directors became more independent, monitoring the audit companies and quickly replacing bad managers. These new measures are important mechanisms to spot and close the loopholes that companies have used as a way to avoid accountability.

The Bottom Line

At the time, Enron's collapse was the biggest corporate bankruptcy to ever hit the financial world (since then, the failures of WorldCom, Lehman Brothers, and Washington Mutual have surpassed it). The Enron scandal drew attention to accounting and corporate fraud, as its shareholders lost $74 billion in the four years leading up to its bankruptcy, and its employees lost billions in pension benefits. As one researcher states, the SarbanesOxley Act is 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." (Deakin and Konzelmann, 2003). Increased regulation and oversight have been enacted to help prevent corporate scandals of Enron's magnitude. However, some companies are still reeling from the damage caused by Enron. Most recently, in March 2017, a judge granted a Toronto-based investment firm the right to sue former Enron CEO Jeffery Skilling, Credit Suisse Group AG, Deutsche Bank AG and Bank of America's Merrill Lynch unit over losses incurred by purchasing Enron shares.

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Enron Case study

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This Enron case study presents our own analysis of the spectacular rise and fall of Enron. It is the first in a new series assessing organisations against ACG’s Golden Rules of corporate governance and applying our proprietary rating tool. As we say in our business ethics examples homepage introducing this series, the first and most critical rule is an ethical approach, and this should permeate an organisation from top to bottom. We shall therefore always start with an assessment of the ethical approach of the organisation. The way this creates the culture determines the performance in relation to the other four Rules.

The Enron case study: history, ethics and governance failures

Introduction: why Enron? Why pick Enron? The answer is that Enron is a well-documented story and we can apply our approach with the great benefit of hindsight to show how the end result could have been predicted. It is also a good example to illustrate how ethics drives culture which in turn pushes the ethical boundaries and is a key influence on all the four other key elements of good corporate governance. Hence, in advance of using our own membership for the survey input we can apply the very detailed findings from the post crash dissection of Enron. Readers who are interested can go to Wikipedia and burrow into the history of Enron and its major players. They can also study the various accounts that have been written and which are referred to in Wikipedia. We particularly commend “The Smartest Guys in the Room”, the story of Enron’s rise and fall, by Bethany McLean and Peter Elkind, and we gratefully acknowledge the valuable insights we have drawn from this fascinating book in producing our Enron case study. Below is a brief résumé of Enron’s spectacular rise in fifteen years to a market valuation of nearly $100bn and its precipitous collapse. We have prepared a detailed history (around 20,000 words) with our own annotations, which will soon be available as an ebook for those who would like to draw their own conclusions. We have also applied our proprietary survey tool to Enron and imagined how the various stakeholder groups might have responded to a business ethics survey at a critical time in Enron’s history, mid 2000, eighteen months before it suddenly collapsed. The results of this survey are summarised below.

History of Enron Enron was created in 1986 by Ken Lay to capitalise on the opportunity he saw arising out of the deregulation of the natural gas industry in the USA. What started as a pipelines company was transformed by the vision of a McKinsey consultant, Jeff Skilling, who had the idea of applying models used in the financial services industry to the deregulated gas industry. He persuaded Enron to set up a Gas Bank through which buyers and sellers of natural gas could transact with each other using an intermediary (Enron) whose contractual arrangements would provide both parties with reliability and predictability regarding pricing and delivery. Enron duly recruited him

to run this business and he rapidly built up a major gas trading operation through the early nineties. During this time Enron was extending its pipeline operations into a wider power supply business, initially in the USA and then on an international scale, completing a large plant at Teesside in the UK and contracting to build a huge plant near Mumbai in India. In due course it had deals all round the globe, from South America to China. The hard driving expansion of Enron’s power business worldwide created a global reputation for Enron. Skilling’s vision was to transform Enron into a giant, asset-light operation, trading power generally and his next target was trading electricity. Lay was lobbying Washingt on hard to deregulate electricity supply and in anticipatio n he and Skilling took Enron San Francisco, California. The US West Coast was an early target for its aggressive and misguide into California expansion. , buying a power 0Sa ve plant on

the west coast. Enron’s national reputation rested on the rapid expansion of its domestic business and its steadily growing revenue and earnings from trading. So on the back of his track record, Skilling was appointed Chief Operating Officer by Ken Lay and he then embarked upon transformi ng the whole of Enron to reflect his vision.

Observing the dotcom boom, Skilling decided Enron could create a business based on a broadband network which could supply and trade bandwidth and he set out to build this at a great pace.

However, the experiment in deregulation in California didn’t work well and in due course was reversed with recriminations all round. Moreover, the international business expansion wasn’t underpinned by adequate administration and many of the contracts later turned bad. So Enron then took the decision to build on its international presence by becoming a global leader in the water industry and bought a big water company in the UK, following it up with a big deal in Argentina. At this point, around 2000, Enron’s reputation was still riding high and Lay and Skilling were looked up to as visionary thinkers and top business leaders. However, as we see elsewhere in this case study, the rapid expansion had run well ahead of Enron’s ability to fund it, and to address the problem, it had secretly created a complex web of off-balance sheet financing vehicles. These, unwisely, were ultimately secured, and hence dependent, on Enron’s rapidly rising share price. Also, its hard driving culture was underpinned by incentive schemes which promised, and delivered, huge rewards in compensation packages to outstanding performers. The result was that, to achieve results, aggressive accounting policies were introduced from an early stage. In particular, the use of mark to market valuation on contracts produced artificially large earnings, disguising for some years underlying poor profitability in major parts of the business. This, of course, meant that Enron was not generating adequate cashflow, while spending extravagantly on expansion, and eventually it blew up suddenly and dramatically. Colleagues of this author who met Lay and had dealings with Enron confirm that there was scepticism in the market about Enron’s profitability and its cash position. Suspicions grew that Enron’s earnings had been manipulated and in late summer 2001 it emerged that its Chief Finance Officer had privately made himself rich at Enron’s expense through the off-balance sheet vehicles. About this time the dotcom boom ended suddenly and for Enron, this coincided with the international power business going radically wrong, the broadband business having to be shut down, the water business collapsing and the electricity services business getting into serious trouble in California. Enron’s share price started to slide and Skilling, appointed Chief Executive Officer in January 2001, resigned in August.

Enron’s share price then rapidly declined, triggering repayment clauses in the financing vehicles which Enron couldn’t handle. Its credit rating went to junk status, which caused the share price to collapse and triggered further crystallising of debt obligations. Banks refused further finance, suppliers refused to supply and customers stopped buying. At the beginning of December 2001, Enron filed for the biggest bankruptcy the USA had yet seen. This, in turn, took down one of the largest accounting firms in the world, Arthur Andersen, which was deemed to have so compromised its professional standards in its dealings with its client Enron that it was in many ways complicit in Enron’s criminal behaviour.

The second half of this Enron case study assesses business ethics and the impact on corporate governance, as measured against our Five Golden Rules.

Ethical assessment Enron didn’t start out as an unethical business. As we have seen in this case study, what introduced the virus was the pursuit of personal wealth via very rapid growth. This led to the introduction of quite extreme incentive schemes to attract and motivate very bright and driven people, which, in turn, led to an unhealthy focus on short term earnings. The next step was, naturally, to look at how earnings could be massaged to achieve the aggressive revenue and earnings targets. Since the massaged figures for growth in...