Enron Corporation: From Riches To Rags
How can it be possible for a company to go from being ranked by Fortune magazine as the nation’s “most innovative company” for six years in succession, to filing for Chapter 11 Bankruptcy Protection less than a decade later? The tragic fall of Enron Corporation at the end of 2001 was a shock to the world and a wake up call to the business community in its entirety. Its repercussions have shaped the way that the financial sector is organized today, and the scandal will forever remain one of the most notorious examples of fraudulent behavior that was successfully executed for so long and concealed from so many.
To begin to understand this complicated scandal, it is helpful to consider the ways in which Enron Corporation was initially able to rise to success. Enron was officially formed in 1985 in a merger between natural gas pipeline companies Houston Natural Gas Company and InterNorth Incorporated, with Kenneth Lay appointed as the new company’s CEO. The newly deregulated natural gas industry meant that Enron could no longer claim exclusive access to the gas pipelines, and therefore needed to develop alternative strategies to generate revenue. CEO Lay, with the guidance of consultant Jeffrey Skilling, promptly took action to rebrand the company into a supplier and trader of energy, essentially playing the role of a middleman between the energy producers and their buyers. They named their product “the energy derivative”, and quickly began to earn large profits and dominate the market for these highly trade worthy contracts. Just five years later in 1990, Lay founded the Enron Finance Corporation and, impressed with his prior work, designated Jeffrey Skilling to lead the new corporation.
At the time, Skilling was on a mission to ensure that the company culture aligned with Enron’s new image as an eminent trading company. He set out to cultivate an immensely competitive environment, and developed the Performance Review Committee (PRC), which became known as the most ruthless employee rating system in the nation. Employees were judged solely on the amount of profit they generated, thus creating an environment of fear and secrecy. One of his early hires, Andrew Fastow, performed well in these conditions and quickly rose through the ranks, becoming the Chief Financial Officer a few years later on. In January of 1992, however, Skilling received approval from the Securities Exchange Commission to utilize a mark-to-market method of accounting to record the company’s finances, rather than the traditional historical cost method. While this may seem like an insignificant detail at first glance, this simple alteration actually laid the foundation for much of the fraud that would be committed over the next decade. Upon receiving this approval, Skilling and his employees enjoyed a champagne celebration at the Enron corporate headquarters, while the world remained in the dark about the scheme that was about to transpire.
Shortly after, Enron decided to diversify its business activities using their newfound success with the energy trading model. They developed the mindset that if they could sell energy contracts, then they could theoretically sell, 'anything that anyone was willing to trade…[including] coal, paper, steel, water, and even weather”. In 1999, they launched EnronOnline, a web based platform that enabled them to better manage their contract trade deals. The firm began to encounter challenges, however, when some of these deals did not meet profit expectations, and the company was forced to decide between reporting a loss, or fudging the numbers to keep Wall Street happy. As the world would find out in the succeeding months, they chose the latter option. According to the Corporate Finance Institute, this decision to initiate the fraudulent behavior was in large part due to the “information asymmetry”, between the company’s executives and the shareholders. It is probable that the team of managers were provided with personal incentives that correlated with the success of the company, and therefore were motivated to increase the company’s worth by any means possible to increase their own personal earnings. They proceeded to do this through two unethical and fraudulent practices.
The first aspect of the fraud carried out by Enron is displayed in their use of mark-to-market (MTM) accounting. Although its use is legal, the method differs from the traditional historical cost method because it allows a company to record the value of an asset or a liability based upon current market valuations, which are often very subjective. This form of accounting was common among banks and financial firms, who held assets such as mutual funds that could undergo frequent fluctuation based upon the conditions of the market. When Enron received approval to utilize this system, they were able to abuse it in two key ways. The first was that MTM required constant adjustment of asset values which was often based on the company’s own discretion, allowing Enron to report increases in assets regardless of whether or not they had actually increased. As a result of this, many of their assets were worth significantly less than what was communicated to the public, but because their assets continued to grow on paper, they were able to meet the expectations of analysts and keep their investors happy. The second issue with Enron’s use of mark-to-market accounting was the fact that the company could recognize revenue before it was earned. In the case of Enron, they would estimate the value of a long-term contract and recognize the entire amount as revenue on their income statement, even though they hadn’t actually completed any tasks or earned any of the stated revenue. This was misleading to the public, who saw the highly inflated profits in Enron’s financial statements, and were under a false impression about the company’s financial health when it came to its revenue. Finally, this form of revenue recognition created a “cash flow differential”, because despite the large amounts of revenue that Enron claimed, they often did not generate any cash through these transactions.
The second aspect of the fraud involved a series of separate companies known as Special Purpose Entities (SPEs), with CFO Andrew Fastow as the predominant brains behind the operation. In the first quarter of 2001, Enron’s profits began to suffer as the volatility in the energy market dropped and the economy headed toward a depression. As a result, the company began to pursue high risk deals in the hope of making up this loss in profit, with little regard for whether these decisions were strategic choices in the long run. To comply with their credit rating agencies, however, Enron needed to maintain an acceptable leverage ratio, a measure of the amount of the company’s assets that are financed with borrowed capital. To adhere to this regulation, Fastow used hundreds of Special Purpose Entities, which essentially enabled the company to borrow more money while concealing their debt from creditors and investors, significantly decreasing their debt to total assets ratio. While the SPEs themselves were permitted within the law, Enron used its own stock to capitalize them, which meant that there was no way to repay their obligations if the value of Enron shares were to decline. Furthermore, while Enron did include a footnote revealing the existence of these SPEs, they failed to disclose the way in which they were set up, leaving investors oblivious to the true facts of the situation. It wasn’t until 2001 that analysts began to question the legitimacy of Enron's business.
The scandal and the catastrophic estimated losses totaling 74 billion dollars were eventually uncovered through a series of events. As increasing numbers of analysts began to question the validity of Enron’s earnings, the price of the company’s shares continued to descend. In February of 2001, Lay retired and Skilling was appointed as CEO, but by August he had also resigned due to personal reasons. In the same month, company vice president Sherron Watkins issued an internal memo expressing her suspicions that Enron had the potential to, “implode under a series of accounting scandals”. On October 16th, Enron announced a third quarter loss of $618 million, and also terminated the Raptor SPE in an attempt to avoid distributing shares. This attracted the scrutiny of Securities Exchange Commission, and before long, Enron announced that the company was under investigation. Two days later, Fastow was fired. On December 2nd, Enron filed for bankruptcy, and on January 9th of 2002, the US Department of Justice opened a criminal investigation. The stock price had fallen from its all time high of $90. 75 to a mere $0. 26 in less than two years.
It is evident that the nationwide catastrophe caused by Enron was a dramatic call to action for the country's executives, who rapidly enacted the Sarbanes-Oxley Act (SOX) in July of 2002, a ruling that would change the accounting field forever more. Legislation was clearly needed to make it more difficult for companies to trade on false pretenses and to create misleading financial statements. SOX was able to accomplish this goal in many ways. The act helped to close down many of the loopholes that Enron had exploited through their use of the SPEs and mark-to-market accounting. It also demanded more stringent accountability and disclosure, making it harder for companies to use these methods to deceive the public through false reporting. By protecting potential whistle-blowers, it ensured that there was a procedure in place to report concerns, should a new situation occur. Finally, SOX altered the rules by which financial auditors worked with corporate boards to prevent future fraudulent activity between them. In addition to the enactment of SOX, changes were made to the Financial Accounting Standards Board to promote more ethical business practices. Legislators hoped that through these changes, an accounting fraud of this magnitude could never pass unnoticed again.
There were several circumstances that should have been seen as major red flags throughout Enron’s operating years. First, the unhealthy competition that Skilling demanded from his employees demonstrates his solely profit-oriented attitude. When looking at his actions in hindsight, it is clear that he had no reservations about leading his team to make money in any way possible. It is also evident that the rest of the senior management, likely because of their results-based performance incentives, also had little concern for honesty or the company's long-term health. This opportunity for personal financial gain was likely a motive that led them to fabricate the details of their finances. The second red flag is apparent in the company’s use of mark-to-market accounting. Even though it was legal, the company’s transition to this system and its subsequent increase in disclosed assets and revenue was suspicious. The approval from the SEC to allow the use of this method could have potentially been better monitored. A final, and possibly the most obvious red flag to consider is Enron's seemingly remarkable performance at the time. As CPA C. William Thomas stated, 'when a company looks too good to be true, it usually is'. Although everyone wanted to believe the prosperity of their investments, they perhaps should have dug deeper to understand the numbers behind Enron's success.
There were many implications of this scandal, some of which were positive changes in legislation as discussed previously, however the vast majority of people affected were the stockholders: the innocent bystanders of a massive scale fraud. In total, a loss of 74 billion dollars was estimated when the company's value plummeted as the scandal unraveled. A portion of those stockholders were Enron's own employees. Specifically, the Enron pension plan holders were punished by a decision that was made on October 17, six weeks before bankruptcy was declared, that immobilized all their investments for 30 days. As a result, when shares started to nosedive, they were powerless to exit and consequently lost everything.
Implications for those that conspired to create the fraud were severe. In January of 2002, just after the commencement of the criminal investigation, J. Clifford Baxtor, Enron’s vice chairman, committed suicide, thus avoiding any further punishment. Later that year, Arthur Andersen LLP, the accounting firm that had been responsible for Enron's audits throughout the scandal, was found guilty of obstruction of justice through its concealment of Enron's financial documents from the SEC. Even though this conviction was later reversed, it was too late and the firm's reputation had already been destroyed. The company went out of business along with Enron. In 2004, Kenneth Lay faced 11 charges including conspiracy and securities fraud, but died of a heart attack the following year as he awaited sentencing. Also in 2004, Jeffrey Skilling was charged with 35 counts of fraud and insider trading and was forever barred from serving as an officer of a publicly held company. He was sentenced to 12 years in federal prison and was only recently released in February 2019. The final major player brought to justice was CFO Andrew Fastow, who also served time in prison after pleading guilty and cooperating with authorities. He was released five years later in 2011.
It is clear that the Enron scandal was a major wake up call to corporations, investors, and legislators across the nation. These seemingly harsh consequences imposed upon the company's executives, as well as the regulations that were put into place following the scandal’s discovery, were absolutely deserved, and the punishment that the major players received was merited. It is evident that the criminals in this case had no regard for the long term wellbeing of the company or its investors, and were concerned solely with their own financial interests. Despite the momentous damage that this scandal caused, its discovery led to the enactment of various regulations on accounting practices, many of which remain in use today. Craig Clay, President of Global Capital Markets at Donnelley Financial Solutions, recently stated that, 'the positive impact of SOX has extended beyond its initial goals, and it should continue to be relevant as it evolves to encompass new developments'. As a nation at the forefront of business and innovation, it is crucial that we always consider the impact of our actions on those around us, and take the principles of ethics into account when making decisions, so that we can prevent tragic situations like the Enron Scandal from reoccurring in the future.