Enron Scandal: The Fall

of a Wall Street Darling

By Investopedia | Updated January 3, 2018 — 11:34 AM EST

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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 off-
balance-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 Sarbanes-
Oxley 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

0Save

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
anticipati
on he and
Skilling
took
Enron
into San Francisco, California. The US West Coast was an early target for its aggressive and misguided
California expansion.
, buying a
power 0Save
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 earnings still left a shortfall in cash, Enron quickly
maxed out on its borrowing abilities.

But issuing more equity would have hurt the share price, on which most of
the incentives were based. So schemes had to be created to produce funding
secretly and this funding had to be hidden. In this way, an amoral and
unethical culture developed in Enron in which customers, suppliers and even
colleagues were misled and exploited to achieve targets. And the top
management, who were rewarding themselves with these same incentive
schemes, boasted that a pure, market-driven ethos was propelling Enron to
greatness and deluded themselves that this equated to ethical behaviour.
Lay even lectured the California authorities, whom Enron was cheating, that
Enron was a model of business ethics.
Finally, the respected Arthur Andersen allowed greed for fees to over-rule
the strong business ethics tradition of its founder and caused it to succumb
to bending and suspending its professional standards, with fatal results.

Impact on Corporate Governance

Our five Rules of Good Corporate Governance start with the need for an
ethical culture. Having established that Enron’s culture became
progressively more deficient in this regard, let’s consider briefly the impact
of this failure in business ethics on the other Rules.

Clear goal shared by all key stakeholders

Lay and, particularly Skilling, engendered in all the staff of Enron the goal
of driving up the share price to the virtual exclusion of all else. The goal of
achieving a long term satisfaction from a stable customer base took a
distant second place to signing up deals. In California, the customers were
deliberately exploited by the traders to the maximum extent their ingenuity
could achieve. Even internally, the Chief Finance Officer’s funding scheme
was designed to make him rich at his employer’s expense.

Strategic management
As a McKinsey consultant specialising in strategy, Skilling had a very clear
vision, at least initially, of what he wanted Enron to achieve. However, he
wasn’t interested in management per se and allowed operational
management to wither. But his vision of a huge trading enterprise wasn’t
carried down to the next level of developing and implementing practical
business plans, as evidenced by his crazy launch into broadband, a field in
which he had no personal knowledge or experience and in which Enron had
almost no capability or likelihood of raising the funds required to implement
the project

Organisation resourced to deliver

Skilling became COO on the departure of a very tough and experienced
predecessor. Even at that point, Enron had been expanding at a rate which
outran its ability to set up appropriate and adequate administrative systems
and controls. Added to which it had always been short of funds. Skilling’s
lack of interest in operational management meant that on his appointment
at COO, he made a poor situation much worse by making bad managerial
appointments. His focus on rapid growth incentivised by very generous
compensation schemes, and with inadequate spending controls, created a
totally dysfunctional organisation.

Transparency and accountability

From the early stages, Enron’s focus on earnings and share price growth and
the related financial incentives led to a necessary lack of transparency as
the figures were fiddled.. One could argue that Enron felt very much
accountable to their shareholders for delivering consistent above average
growth in Enron’s market capitalisation. However, this growth was achieved
by subterfuge and deception. Certainly the dealings in California were as far
from transparent as it was possible to be.

Finally, we bring a unique perspective to this Enron case

study by using our proprietary survey tool, the ACGi, to rate
the company, as at June 2000, and drawing conclusions from
the results.

Conclusion and rating by our Survey tool

The flaws in Enron should have been spotted from early on, and indeed were
periodically commented on by various observers from the early nineties
onward. If independent ethical and corporate governance surveys had been
conducted by independent parties they would have highlighted the growing
problems. To illustrate, consider the hypothetical survey summarised in the
following chart. 

The scores out of ten (high is good) result from a set of questions which aim
at deriving an independent, unbiased view from the interviewees, based on
observations of corporate behaviour. What we have called the “sniff test”
represents the personal view of the interviewee and would take into
account their gut feel about the corporation and its management and
owners. The highlighted scores would point the observer to clear problem
areas.
 Click to enlarge the image.
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One would conclude from this survey in June 2000 that:

 neither customers, suppliers, financiers nor local communities rated

Enron’s morality in terms of business ethics
 customers and local communities thought they were breaking
regulations
 customers and suppliers thought they were probably bending their own
rules
  customers, shareholders, suppliers, financiers and local communities
thought they were not truly honest.

It is clear with the benefit of hindsight that what started out as an

imaginative and ground-breaking idea, which transformed the natural gas
supply industry, rapidly evolved into a megalomaniac vision of creating a
world-leading company. Intellectual self confidence mutated into contempt
for traditional business models and created an environment in which top
management became divorced from reality. The obsessive focus on driving
the share price obscured the lack of basic controls and benchmarks and the
progressive dishonesty in generating revenue and earnings figures in order to
deceive the stock market led to the management deceiving themselves
about the true situation. 

Right up to nearly the end, Enron complied with all its regulatory
requirements. The failings in these regulations led directly to Sarbanes-
Oxley. But all the extra reporting in SarBox didn’t prevent the global
financial meltdown in 2008 as the banks gamed the regulatory system. Now
we have Dodd-Frank. What we actually need is independent Corporate
Governance surveys.

If you found this summary useful, you may be interest