- Contributors
Twenty Years Later: The Lasting Lessons of Enron
Michael Peregrine is partner at McDermott Will & Emery LLP, and Charles Elson is professor of corporate governance at the University of Delaware Alfred Lerner College of Business and Economics.
This spring marks the 20th anniversary of the beginning of the dramatic and cataclysmic demise of Enron Corp. A scandal of exceptional scope and impact, it was (at the time) the largest bankruptcy in American history. The alleged business practices of its executives led to numerous individual criminal convictions. It was also a principal impetus for the enactment of the Sarbanes-Oxley Act and the evolution of the concept of corporate responsibility. As such, it is one of the most consequential corporate governance developments in history.
Yet a new generation of corporate leaders has assumed their positions since then; for others, their recollection of the colossal scandal may have faded with the years. And a general awareness of corporate responsibility principles is no substitute for familiarity with the governance failings that reenergized, in a lasting manner, the focus on effective and responsible governance. A basic appreciation of the Enron debacle and its governance implications is essential to director engagement.
Enron was formed as a natural gas pipeline company and ultimately transformed itself, through diversification, into a trading enterprise engaged in various forms of highly complex transactions. Among these were a series of unconventional and complicated related-party transactions (remember the strangely named Raptor, Jedi and Chewco ventures) in which members of Enron’s financial leadership held lucrative financial interests. Notably, the management team was experienced, and both its board and its audit committee were composed of a diverse group of seasoned, skilled, and prominent individuals.
The company’s rapid financial growth crested in March 2001, with media reports questioning how it could maintain its high stock value (trading at 55 times its earnings). Famous among these was the Fortune article by Bethany McLean, and its identification of potential financial reporting problems at Enron. [1] In a dizzying series of events over the next few months, the company’s stock price collapsed, its CEO resigned, a bailout merger failed, its credit was downgraded, the SEC began an investigation of its dealings with related parties, and it ultimately declared bankruptcy. Multiple regulatory investigations followed, several criminal convictions were obtained and Sarbanes-Oxley was ultimately enacted to curb the perceived abuses arising from Enron and several similar accounting scandals. [2]
There remain multiple important, stand-alone governance lessons from Enron controversy of which all directors would benefit:
1. The Smartest Guys in the Room . The type of aggressive executive conduct that contributed heavily to the fall of Enron was not unique to the company, the industry or the times. In the absence of an embedded culture of corporate ethics and compliance, there is always the potential for some executives to pursue “edge of the envelope” business practices, especially when those practices produce meaningful near term financial or other operational results. That attitude, combined with weak board oversight practices, can be a disastrous combination for a company.
Even though commerce has made great progress since then on internal controls, corporate responsibility ultimately depends upon the integrity of management, and the skill and persistence of board oversight. [3]
2. The Critical Importance of Board Oversight . As the company began to implode, Enron’s board commissioned a special committee to investigate the implicated transactions, directed by William C. Powers Jr., then dean of the University of Texas School of Law. The Powers Report, as it came to be known, outlined in staggering detail a litany of board oversight failures that contributed to the company’s collapse. [4]
These included inadequate and poorly implemented internal controls; the failure to exercise sufficient vigilance; an additional failure to respond adequately when issues arose that required a prompt and serious response; cursory review of critical matters by the audit and compliance committee; the failure to insist on a proper information flow; and an inability to fully appreciate the significance of some of the information with which the board was provided. [5]
3. Spotting Red Flags . Amongst the most damaging of the governance breakdowns was the failure to question the legitimacy of the related-party transactions for which so many internal controls were required. These deficiencies served to bring a once significant company and its officers to their collective knees and offer many lasting governance lessons. As the Powers Report concluded with brutal clarity, a major portion of the company’s business plan—related-party transactions—was flawed. [6]
These transactions were replete with risky conflicts of interest involving management. There was a significant “forest for the trees” concern—an inability to recognize that conflicts of such magnitude that required so many board-approved internal controls and procedures should never have been authorized in the first place. All this, despite the fact that the individual Enron directors were people of accomplishment and capability who had been recognized by the media as a well-functioning board. [7]
Yet, they lacked the actual necessary independence to recognize the red flags waving before them. Their varied relationships with company leadership made them all-too-comfortable with what they were being told about the company. [8] This connection made it difficult for them to recognize the dangers associated with the warning signals that the conflicted transactions projected. Indeed it was the revelation of these conflicts that attracted media attention and ultimately “brought the house down”. [9]
4. It Can Still Happen . The 2020 scandal encompassing the German financial services company Wirecard offers one of the latest high profile (international) examples of how alleged aggressive business practices, lax internal and auditor oversight, accounting irregularities and limited regulatory supervision can combine into a spectacular corporate collapse that prompted numerous government fraud investigations. It is for no small reason that the Wirecard scandal is referred to as the “German Enron”. [10]
5. A Significant Legacy . Yet the Enron controversy remains fundamentally relevant as the spark behind the corporate responsibility environment that has reshaped attitudes about corporate governance for the last 20 years. It’s where it all began—the seismic recalibration of corporate direction from the executive suite back to the boardroom, where it belongs. It birthed the fiduciary guidelines, principles, and “best practices” that serve as the corridors of modern corporate governance, developed in direct response to the types of conduct so criticized in the Powers Report. [11]
And that’s important for today’s board members to know. [12] Because over the years, the message may have lost its sizzle. The once-key oversight themes incorporated within “plain old” corporate responsibility seem to be yielding the boardroom field to the more politically popular themes of corporate social responsibility. And, while still important, corporate compliance seems to have had its “fifteen years of fame” in the minds of some executives; the organizational initiative has turned elsewhere.
But the pendulum may be swinging back. There is a renewed recognition that compliance programs can atrophy from lack of support. The new regulatory administration in Washington may return to an emphasis on organizational accountability. As Delaware decisions suggest, shareholders may be growing increasingly intolerant of costly corporate compliance and accounting lapses. And there’s a renewed emphasis on the role of the whistleblower, and the board’s role in assuring the support and protection of that role.
So it may be useful on this auspicious anniversary to engage the board on the Enron experience, in a couple of different ways. First, include an overview as part of formal director “onboarding” efforts. Second, have a board level conversation about expectations of oversight, and spotting operational and ethical warning signs. And third, reconsider the Enron board’s critical and self-admitted failures, in the context of today’s boardroom culture. [13]
Such a conversation would be a powerful demonstration of a board’s good-faith commitment to effective governance, corporate responsibility and leadership ethics.
1 Bethany McLean, “Is Enron Overpriced?” Fortune, March 5. 2001. https://archive.fortune.com/magazines/fortune/fortune_archive/2001/03/05/297833/index.htm. (go back)
2 See , Michael W. Peregrine, Corporate BoardMember , Second Quarter 2016 (henceforth “Corporate BoardMember”). (go back)
3 See , e.g., Elson and Gyves, In Re Caremark : Good Intentions, Unintended Consequences, 39 Wake Forest Law Review, 691 (2004). (go back)
4 Report of the Special Investigation Committee of the Board of Directors of Enron Corporation, February 1, 2002. http://i.cnn.net/cnn/2002/LAW/02/02/enron.report/powers.report.pdf. (go back)
5 See , Michael W. Peregrine, “The Corporate Governance Legacy of the Powers Report” Corporate Counsel , January 23, 2012 Monday. (go back)
6 See , Michael W. Peregrine, “Enron Still Matters, 15 Years After Its Collapse”, The New York Times , December 1, 2016. (go back)
7 F.N. 5, supra . (go back)
8 See , Elson and Gyves, “The Enron Failure and Corporate Governance Reform”, 38 Wake Forest Law Review 855 (2003) and Elson, “Enron and the Necessity of the Objective Proximate Monitor”, 89 Cornell Law Review 496 (2004). (go back)
9 John Emshwiller and Rebecca Smith, “Enron Posts Surprise 3rd-Quarter Loss After Investment, Asset Write-Downs”, The Wall Street Journal , October 17, 2001. https://www.wsj.com/articles/SB1003237924744857040. (go back)
10 Dylan Tokar and Paul J. Davies, “Wirecard Red Flags Should Have Prompted Earlier Response, Former Executive Says” The Wall Street Journal , February 8, 2021. https://www.wsj.com/articles/wirecard-red-flags-should-have-prompted-earlier-response-former-execu tive-says-11612780200. (go back)
11 Corporate BoardMember , supra . (go back)
12 See Peregrine, “Why Enron Remains Relevant”, Harvard Law School Forum on Corporate Governance, December 2, 2016. (go back)
13 Corporate BoardMember , supra. (go back)
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ENRON'S MANY STRANDS: A CASE STUDY
ENRON'S MANY STRANDS: A CASE STUDY; A Video Study Of Enron Offers A Picture of Life Before the Fall
By Shaila K. Dewan
- Jan. 31, 2002
In April 2000, Enron was still flying high, at least publicly. Jeffrey K. Skilling, the president and chief operating officer at the time, faced a video camera and spoke enthusiastically about the corporate culture that would, he insisted, enable Enron to go from the world's largest energy-trading company to the world's leading company, period.
''People have an obligation to dissent in this company,'' Mr. Skilling said, detailing Enron's core values of respect, communication, excellence and integrity as company posters of a sunflower and a smiling baby girl flashed on the screen of what became a multimedia computer presentation. ''I mean, I sit up here on the 50th floor, in the library. I have no idea what's going on down there, so if you've got a problem with it, speak up. And if you don't speak up, that's not good.''
The video was part of what was supposed to be and, for a few months, was a case study of a phenomenal transformation, prepared by two University of Virginia business professors with exclusive access to Enron's top executives. But what was meant to inspire students has become a cautionary tale, a study in hubris all the more valuable for its intimate picture of life before the fall.
The professors, Robert F. Bruner and Samuel E. Bodily, who teach at the Darden Graduate School of Business Administration, first saw Mr. Skilling in November 1999, when he spoke at the school. What they saw then was someone, they said, who might be the next John F. Welch, leading a company whose story could be told alongside those of the other giants like Mr. Welch's General Electric, or Home Depot or Wal-Mart Stores.
What they see now is a business plan that reality refused to endorse. Even when they shot their first interviews -- the bulk of their 15 hours of film -- in May 2000 the company was already buying time, the professors say now.
''All of the partnerships are there to hide the debt and make it possible to keep going,'' Dr. Bodily said in a phone interview this week. ''The strategy seemed to be, 'I lost money in the poker game, so now I'll take the mortgage down to the casino and gamble even harder,' '' he said. '' 'By tomorrow, I won't have to tell them anything.' ''
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How the Enron Scandal Changed American Business Forever
It’s the kind of historic anniversary few people really want to remember.
In early December 2001, innovative energy company Enron Corporation, a darling of Wall Street investors with $63.4 billion in assets, went bust. It was the largest bankruptcy in U.S. history. Some of the corporation’s executives, including the CEO and chief financial officer, went to prison for fraud and other offenses. Shareholders hit the company with a $40 billion lawsuit, and the company’s auditor, Arthur Andersen, ceased doing business after losing many of its clients.
It was also a black mark on the U.S. stock market. At the time, most investors didn’t see the prospect of massive financial fraud as a real risk when buying U.S.-listed stocks. “U.S. markets had long been the gold standard in transparency and compliance,” says Jack Ablin, founding partner at Cresset Capital and a veteran of financial markets. “That was a real one-two punch on credibility. That was a watershed for the U.S. public.”
The company’s collapse sent ripples through the financial system, with the government introducing a set of stringent regulations for auditors, accountants and senior executives, huge requirements for record keeping, and criminal penalties for securities laws violations. In turn, that has led in part to less choice for U.S. stock investors, and lower participation in stock ownership by individuals.
In other words, it was the little guy who suffered over the last two decades.
Americans lost trust in the stock market
The collapse of Enron gave many average Americans pause about investing. After all, if a giant like Enron could collapse, what investments could they trust? A significant number of Americans have foregone participating in the tremendous stock market gains seen over the last two decades. In 2020, a little more than half of the population (55%) owned stocks directly or through savings vehicles such as 401Ks and IRAs. That’s down from 60% in the year 2000, according to the Survey of Consumer Finances from the U.S. Federal Reserve.
That could have had a large financial impact on some folks. For instance, an investment of $1,000 in the S&P 500 at the beginning of 2000 would recently have been worth $4,710, including reinvested dividends. Wealthier people, who often employ professionals to handle their investments, were more likely to stick with their stocks, while middle class and poorer people couldn’t take the risk. Without doubt this drop in stock market participation has contributed to the growing levels of wealth inequality across the U.S.
It became harder for companies to IPO
While lack of trust in the market is a direct consequence of Enron’s mega fraud, the indirect consequences of government actions also seem to have hurt Main Street USA.
Immediately following the bankruptcy, Congress worked on the Sarbanes-Oxley legislation, which was meant to hold senior executives responsible for listed company financial statements. CEOs and CFOs are now held personally accountable for the truth of what goes on the income statement and balance sheet. The bill passed in 2002 and has been with us since. But it has also drawn harsh criticisms.
“The most important political response was Sarbanes-Oxley,” says Steve Hanke, professor of applied economics at Johns Hopkins University. “It was unnecessary, and it was harmful.”
In many ways, the legislation wasn’t needed because the Justice Department and the Securities Exchange Commission already had the powers to prosecute executives who cooked the financial books or at a minimum were less than transparent with the truth, Hanke says.
The direct result of the legislation was that public companies got dumped with a load of bureaucratic form-filling, and executives would be less likely to take on entrepreneurial risks, Hanke says. There is also much ambiguity in the law about what is or what isn’t allowed and what are the ultimate consequences of non-compliance. “You don’t know what you are facing in terms of penalties, so you back off of everything risky,” he says.
Quickly, that meant the stock market underwent two significant changes. First, fewer companies are listed now than since the 1970s. In 1996, during the dot-com bubble, there were 8,090 companies listed on stock exchanges in the U.S., according to data from the World Bank. That figure had fallen to 4,266 by 2019.
That drop was partially a reflection of the regulatory burden of companies wishing to go public, experts say. “It costs a lot of money to employ the securities attorneys needed for Sarbanes-Oxley,” says Robert Wright, a senior fellow at the American Institute of Economic Research and an economic historian. “Clearly, fewer companies can afford to meet all these requirements.”
Companies now wait under they are far larger before going public than they did before the Sarbanes-Oxley rules were introduced. Yahoo! went public with a market capitalization of $848 million in April 1996, and in 1995 Netscape got a valuation of $2.9 billion. Compare that to the $82 billion IPO valuation for ride share company Uber in 2019, or Facebook $104 billion IPO value in 2012.
Now, companies grow through investments that don’t require a public market listing and that don’t involve heavy bureaucratic costs. Instead, startups go to venture capital firms or private equity. The recent rise in the use of Special Acquisition Corporations (SPACs) is seen by some as a relatively easy way to skirt some of the burdensome regulations of listing stocks. However, SPACs do nothing to reduce ongoing costs or burden of complying with the Sarbanes-Oxley rules.
But when companies stay private longer, they spend more time without the public accountability required of listed companies. Former blood testing company Theranos famously remained private in a move some theorized was to avoid publicizing internal data. Because of the high barriers Sarbanes-Oxley placed on going public, the business world is now littered with large, private companies that don’t have to reveal their inner workings.
Delaying going public also affects Main Street because most individual investors cannot buy shares in companies that aren’t public. They haven’t been able to share in the profits from the speedy early-stage corporate growth that is typically seen in companies like Facebook and Uber.
Put simply, the Sarbanes-Oxley regulations have chased away some investing opportunities from the public market to the private ones. And in doing so have excluded small investors from participating—and gaining.
“Now smaller investors are shut out and all the big economic profits go to venture capitalists and the like,” Wright says. That, in many ways, is the legacy of Enron.
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The Fall of Enron
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About The Authors
Paul M. Healy
Krishna G. Palepu
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Lessons from the Enron Scandal
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Kirk Hanson, executive director of the Markkula Center for Applied Ethics, was interviewed about Enron by Atsushi Nakayama, a reporter for the Japanese newspaper Nikkei.
On March 5, 2002, Kirk Hanson, executive director of the Markkula Center for Applied Ethics, was interviewed about Enron by Atsushi Nakayama, a reporter for the Japanese newspaper Nikkei . Their Q & A appears below:
Nakayama: What do you think are the most important lessons to be learned from the Enron scandal?
Hanson: The Enron scandal is the most significant corporate collapse in the United States since the failure of many savings and loan banks during the 1980s. This scandal demonstrates the need for significant reforms in accounting and corporate governance in the United States, as well as for a close look at the ethical quality of the culture of business generally and of business corporations in the United States.
N: Why did this happen?
H: There are many causes of the Enron collapse. Among them are the conflict of interest between the two roles played by Arthur Andersen, as auditor but also as consultant to Enron; the lack of attention shown by members of the Enron board of directors to the off-books financial entities with which Enron did business; and the lack of truthfulness by management about the health of the company and its business operations. In some ways, the culture of Enron was the primary cause of the collapse. The senior executives believed Enron had to be the best at everything it did and that they had to protect their reputations and their compensation as the most successful executives in the U.S. When some of their business and trading ventures began to perform poorly, they tried to cover up their own failures.
N: Why didn't the company's directors protect the employees and investors?
H: The board of directors was not attentive to the nature of the off-books entities created by Enron, nor to their own obligations to monitor those entities once they were approved. The board did not pay attention to the employees because most directors in the United States do not consider this their responsibility. They consider themselves representatives of the shareholders only, and not of the employees. However, in this case they did not even represent the shareholders well-and particularly not the employees who were shareholders.
N: Why didn't anyone stop Skilling, Lay and Fastow?
H: Jeffrey Skilling and Andrew Fastow changed the business strategy and corporate culture of Enron. In the process, they appeared to make Enron very innovative and very profitable. When the stock is rising and the shareholders are getting rich, there is little incentive for the board of directors and the investment community to question the executives very closely. The board is at fault for permitting the suspension of Enron's own code of conduct to permit the conflicts of interest inherent in the off-books corporations controlled by Fastow. A few analysts recommended their clients stay out of Enron, but not many.
N: Could you tell me how the corporate governance should be changed?
H: I do not think the rules of corporate governance will be changed in significant ways. But boards of directors need to pay closer attention to the behavior of management and the way the company is making money. In too many American companies, board members are expected to approve what management proposes-or to resign. It must become acceptable and mandatory to question management closely. There is little chance the U.S. governance rules will be changed to make boards responsible to the employees as well as to the shareholders. However, board members would be foolish not to pay more attention to how employees and customers and business partners are treated. These greatly affect the long-term value of the shareholders' investment.
N: Don't you think this scandal damaged the new economy's fundamental system?
H: Enron is a prominent example of a "new economy" company. Kenneth Lay and Jeffrey Skilling claimed that Enron was the most innovative company in the United States and at times tried to intimidate reporters or analysts who questioned their strategy. In the new economy, new kinds of companies have been created. Enron's collapse will encourage investors, analysts, reporters, and employees to ask "old economy" questions about these new economy companies: How does this company make money? Can it sustain this strategy over the long term? How do those who work in and with this company feel about it? The new economy has lost some of its appeal after the collapse of many dot.com companies and of Enron.
N: Can we believe analysts' strong "buy" recommendations from now on?
H: Many have questioned the overly optimistic "buy" recommendations analysts have issued in recent years, fearing they had conflicts of interest because of the underwriting business their firms did for dot.coms or because of the investment industry culture which rewarded analysts who were bullish on the new economy. I think there will be much closer scrutiny of analysts' recommendations in the months and years ahead, and a close look at the conflicts of interest of individual analysts. Analysts who are always bullish will be less likely to be believed.
N: What reforms should Congress, the SEC, and others institute post-Enron?
H: I believe accounting regulations should be altered to prohibit ownership of both auditing and consulting services by the same accounting firm. Accounting firms are already moving to sever their consulting businesses. The SEC should probably adopt additional disclosure requirements. Various regulators should tighten requirements for directors to be vigilant and provide protections for whistleblowers who bring improper behavior to public attention. But, in the final analysis, the solution to an Enron-type scandal lies in the attentiveness of directors and in the truthfulness and integrity of executives. Clever individuals will always find ways to conceal information or to engage in fraud.
N: How can credibility be recovered with investors?
H: U.S. firms and foreign firms listed on U.S. stock exchanges will need to demonstrate that they have eliminated all off-books accounts which distort the public's understanding of the financial health of the organization. They may need to pledge that they will not suspend the company's code of conduct, or at least report to the public when they do. Finally, every company will need to demonstrate that its board of directors is vigorous, vigilant, and that its procedures will enable it to uncover any questionable behavior. Companies may need to adopt a set of "governance best practices" to regain the trust of the market.
N: Some say Enron's collapse was caused by its stock options system. Do you think the executive compensation system should be reformed, and if so, how?
H: The stock option system is not itself the problem. Excessive stock options and excessive corporate compensation give corporate executives too many incentives to manipulate the financial accounts and the stock price of the company. When huge cash or options bonuses are dependent upon achievement of one or a few narrowly defined profit or growth goals, the temptation to manipulate the numbers to get the rewards will be too great. The problem is not the stock option system but the excessive compensation given to executives in the United States, particularly compared to the salaries of regular employees of the company. U.S. companies should look more like Japanese companies in the ratio of the salaries of top executives to those of regular employees.
N: Will stock prices continue to be down because the investors' faith has been shaken? The other day the blue chips like GE and IBM had to reassure investors about the strength of their financial controls.
H: I believe the stock prices of new economy companies will continue to show an "Enron effect" for many months to come. Until an individual company convinces the market that it has rid itself of any questionable practices and has improved its governance systems, it will not be evaluated fully.
N: Don't you think this kind of scandal will be a bad influence on the U.S. economy, which is recovering from recession?
H: Enron has clearly done some damage to the U.S. economy, but it will not hold up recovery from the current recession. The fundamental health of the U.S. economy is strong and now getting stronger. Some individual new economy companies will have depressed stock prices for some time, but they, too, will recover as they demonstrate that they are prepared to prevent Enron-like behavior.
N: You mentioned in Newsweek magazine that Enron will become the morality play of the new economy. Could you give me a more concrete idea what you mean by this?
H: I do believe Enron will be the morality play of the new economy. It will teach executives and the American public the most important ethics lessons of this decade. Among these lessons are:
You make money in the new economy in the same ways you make money in the old economy - by providing goods or services that have real value.
Financial cleverness is no substitute for a good corporate strategy.
The arrogance of corporate executives who claim they are the best and the brightest, "the most innovative," and who present themselves as superstars should be a "red flag" for investors, directors and the public.
Executives who are paid too much can think they are above the rules and can be tempted to cut ethical corners to retain their wealth and perquisites.
Government regulations and rules need to be updated for the new economy, not relaxed and eliminated.
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The Enron Litigation Case Study: Lessons from a Corporate Catastrophe
The Enron scandal stands as one of the most infamous examples of corporate fraud in American history. The collapse of Enron Corporation not only led to significant financial losses for investors but also brought about widespread legal ramifications, regulatory reforms, and a rethinking of corporate governance practices. This case study delves into the intricacies of the Enron litigation, highlighting the key events, legal proceedings, and lasting impacts of the scandal.
Table of Contents
The Rise and Fall of Enron
Enron Corporation, once a titan in the energy sector, was founded in 1985 through the merger of Houston Natural Gas and InterNorth. Under the leadership of CEO Kenneth Lay, Enron rapidly expanded its operations, diversifying into various energy-related ventures and pioneering new trading strategies. By the late 1990s, Enron was hailed as one of the most innovative companies in America, boasting a market capitalization of over $60 billion.
However, behind the facade of success, Enron was engaged in a series of complex and fraudulent accounting practices designed to inflate its profits and hide its mounting debts. The use of special purpose entities (SPEs) and mark-to-market accounting allowed Enron to manipulate its financial statements, deceiving investors, analysts, and regulators.
The Unraveling of the Scandal
The downfall of Enron began in earnest in late 2001, when a series of investigative reports by financial analysts and journalists started to reveal discrepancies in the company’s financial statements. On October 16, 2001, Enron announced a massive third-quarter loss and disclosed the existence of over $1 billion in previously unreported debt. This announcement triggered a rapid decline in investor confidence and a precipitous drop in Enron’s stock price.
On December 2, 2001, Enron filed for bankruptcy, marking the largest corporate bankruptcy in U.S. history at the time. The fallout from Enron’s collapse was extensive, leading to significant financial losses for employees, investors, and pensioners, as well as the dissolution of Arthur Andersen, one of the world’s largest accounting firms, which was implicated in the scandal for its role as Enron’s auditor.
Legal Proceedings and Litigation
The Enron scandal led to a cascade of legal actions, targeting both the company and its executives. Key figures, including Kenneth Lay, Jeffrey Skilling (Enron’s COO and later CEO), and Andrew Fastow (CFO), faced criminal charges for their roles in the fraud.
Kenneth Lay : Charged with conspiracy, securities fraud, and making false statements, Lay was convicted on multiple counts in 2006. However, he died of a heart attack before sentencing, leading to the vacation of his conviction.
Jeffrey Skilling : Skilling was found guilty of conspiracy, securities fraud, and insider trading in 2006 and was sentenced to 24 years in prison. His sentence was later reduced to 14 years, and he was released in 2019.
Andrew Fastow : Fastow, the architect of many of Enron’s fraudulent schemes, pled guilty to conspiracy and was sentenced to six years in prison in 2006. He cooperated with prosecutors, providing valuable testimony against his former colleagues.
In addition to criminal prosecutions, numerous civil lawsuits were filed by investors, employees, and other stakeholders who suffered financial losses due to Enron’s collapse. These lawsuits resulted in significant settlements, including a $7.2 billion settlement in a class-action lawsuit against Enron’s banks, auditors, and law firms.
Regulatory Reforms
The Enron scandal underscored the need for stricter regulatory oversight and reforms in corporate governance. In response, the U.S. Congress enacted the Sarbanes-Oxley Act (SOX) in 2002, which introduced comprehensive changes to improve financial transparency, accountability, and the integrity of corporate disclosures.
Key provisions of SOX include:
- Enhanced financial disclosures and accuracy requirements.
- Increased penalties for corporate fraud.
- Protections for whistleblowers.
- The establishment of the Public Company Accounting Oversight Board (PCAOB) to oversee the auditing profession.
Lessons Learned
The Enron scandal serves as a stark reminder of the potential for corporate malfeasance and the devastating impact it can have on stakeholders. Key lessons from the Enron litigation case study include the importance of:
- Robust internal controls : Effective internal controls and compliance programs are essential to prevent and detect fraudulent activities.
- Transparency and accountability : Transparent financial reporting and accountability are critical to maintaining investor confidence and market integrity.
- Regulatory oversight : Strong regulatory frameworks and oversight mechanisms are necessary to safeguard against corporate misconduct.
- Ethical leadership : Corporate leaders must prioritize ethical behavior and decision-making to foster a culture of integrity and responsibility.
The Enron litigation case study remains a pivotal example of the consequences of corporate fraud and the necessity for rigorous oversight and ethical leadership in the corporate world. While the collapse of Enron was a monumental tragedy for many, the lessons learned from this scandal continue to shape the landscape of corporate governance and financial regulation, aiming to prevent similar occurrences in the future.
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Enron: The Smartest Guys in the Room
Why We Fight
Enron: The Smartest Guys in the Room tells the inside story of the spectacular rise and fall of one of the most scandal-ridden corporations in American history. Based on the best-selling book of the same name, this film takes a look at the collapse of the once seventh-largest company in the United States, where executives misappropriated billions of dollars, leaving investors scrambling and ruining the life-savings of thousands of employees.
Through insider accounts and corporate recordings, the documentary follows the birth of Enron in 1985 to its zenith in 2000, becoming the largest natural gas merchant in North America. Its rise is plagued by unethical and underhanded business practices, including profiteering on the California energy crisis at the expense of the public. The company’s collapse is heralded by the extravagant and outrageous spending of its top executives, who leave the company and its employees in a sinking ship.
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- Table Of Contents
As the boom years came to an end and as Enron faced increased competition in the energy-trading business, the company’s profits shrank rapidly. Under pressure from shareholders, company executives began to rely on dubious accounting practices, including a technique known as “ mark-to-market accounting,” to hide the troubles. Mark-to-market accounting allowed the company to write unrealized future gains from some trading contracts into current income statements, thus giving the illusion of higher current profits. Furthermore, the troubled operations of the company were transferred to so-called special purpose entities (SPEs), which are essentially limited partnerships created with outside parties. Although many companies distributed assets to SPEs, Enron abused the practice by using SPEs as dump sites for its troubled assets. Transferring those assets to SPEs meant that they were kept off Enron’s books, making its losses look less severe than they really were. Ironically, some of those SPEs were run by Fastow himself. Throughout these years, Arthur Andersen served not only as Enron’s auditor but also as a consultant for the company.
In February 2001 Skilling took over as Enron’s chief executive officer , while Lay stayed on as chairman. In August, however, Skilling abruptly resigned, and Lay resumed the CEO role. By this point Lay had received an anonymous memo from Sherron Watkins, an Enron vice president who had become worried about the Fastow partnerships and who warned of possible accounting scandals.
The severity of the situation began to become apparent in mid-2001 as a number of analysts began to dig into the details of Enron’s publicly released financial statements. In October Enron shocked investors when it announced that it was going to post a $638 million loss for the third quarter and take a $1.2 billion reduction in shareholder equity owing in part to Fastow’s partnerships. Shortly thereafter the Securities and Exchange Commission (SEC) began investigating the transactions between Enron and Fastow’s SPEs. Some officials at Arthur Andersen then began shredding documents related to Enron audits.
As the details of the accounting frauds emerged, Enron went into free fall. Fastow was fired, and the company’s stock price plummeted from a high of $90 per share in mid-2000 to less than $12 by the beginning of November 2001. That month Enron attempted to avoid disaster by agreeing to be acquired by Dynegy. However, weeks later Dynegy backed out of the deal. The news caused Enron’s stock to drop to under $1 per share, taking with it the value of Enron employees’ 401(k) pensions, which were mainly tied to the company stock. On December 2, 2001, Enron filed for Chapter 11 bankruptcy protection.
Many Enron executives were indicted on a variety of charges and were later sentenced to prison. Notably, in 2006 both Skilling and Lay were convicted on various charges of conspiracy and fraud. Skilling was initially sentenced to more than 24 years but ultimately served only 12. Lay, who was facing more than 45 years in prison, died before he was sentenced. In addition, Fastow pleaded guilty in 2006 and was sentenced to six years in prison; he was released in 2011.
Arthur Andersen also came under intense scrutiny, and in March 2002 the U.S. Department of Justice indicted the firm for obstruction of justice . Clients wanting to assure investors that their financial statements could meet the highest accounting standards abandoned Andersen for its competitors. They were soon followed by Andersen employees and entire offices. In addition, thousands of employees were laid off. On June 15, 2002, Arthur Andersen was found guilty of shredding evidence and lost its license to engage in public accounting. Three years later, Andersen lawyers successfully persuaded the U.S. Supreme Court to unanimously overturn the obstruction of justice verdict on the basis of faulty jury instructions. But by then there was nothing left of the firm beyond 200 employees managing its lawsuits.
In addition, hundreds of civil suits were filed by shareholders against both Enron and Andersen. While a number of suits were successful, most investors did not recoup their money, and employees received only a fraction of their 401(k)s.
The scandal resulted in a wave of new regulations and legislation designed to increase the accuracy of financial reporting for publicly traded companies. The most important of those measures, the Sarbanes-Oxley Act (2002), imposed harsh penalties for destroying, altering, or fabricating financial records. The act also prohibited auditing firms from doing any concurrent consulting business for the same clients.
Brian Cruver, an Enron employee, wrote Anatomy of Greed: The Unshredded Truth from an Enron Insider (2002), which was adapted as the TV movie The Crooked E (2003). Enron: The Smartest Guys in the Room (2005) is a documentary film about Enron’s rise and fall.
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- PROFESSIONAL ISSUES
The Rise and Fall of Enron
When a company looks too good to be true, it usually is..
- Management Accounting
- Enterprise Risk Management
- Forensic Services
- Accounting & Reporting
If you’re like most, you’ve been astonished, disillusioned and angered as you learned of the meteoric rise and fall of Enron Corp. Remember the company’s television commercial of not so long ago, ending with the reverberating phrase, “Ask why, why, why?” That question is now on everyone’s lips. The Enron case is a dream for academics who conduct research and teach. For those currently or formerly involved with the company, such as creditors, auditors, the SEC and accounting regulators, it’s a nightmare that will continue for a long time.
Formal investigations of Enron are now under way, headed by the company’s board, the SEC, the Justice Department and Congress. The exact causes and details of the disaster may not be known for months. The purpose of this article is to summarize preliminary observations about the collapse, as well as changes in financial reporting, auditing and corporate governance that are being proposed in response by Big Five accounting firms, the AICPA and the SEC.
IN A WAY IT'S SIMPLE, IN A WAY IT'S NOT
On the surface, the motives and attitudes behind decisions and events leading to Enron’s eventual downfall appear simple enough: individual and collective greed born in an atmosphere of market euphoria and corporate arrogance. Hardly anyone—the company, its employees, analysts or individual investors—wanted to believe the company was too good to be true. So, for a while, hardly anyone did. Many kept on buying the stock, the corporate mantra and the dream. In the meantime, the company made many high-risk deals, some of which were outside the company’s typical asset risk control process. Many went sour in the early months of 2001 as Enron’s stock price and debt rating imploded because of loss of investor and creditor trust. Methods the company used to disclose (or creatively obscure) its complicated financial dealings were erroneous and, in the view of some, downright deceptive. The company’s lack of transparency in reporting its financial affairs, followed by financial restatements disclosing billions of dollars of omitted liabilities and losses, contributed to its demise. The whole affair happened under the watchful eye of Arthur Andersen LLP, which kept a whole floor of auditors assigned at Enron year-round.
THE BEGINNING PRESAGES THE END
In 1985, after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston Natural Gas and InterNorth, a Nebraska pipeline company. In the process of the merger, Enron incurred massive debt and, as the result of deregulation, no longer had exclusive rights to its pipelines. In order to survive, the company had to come up with a new and innovative business strategy to generate profits and cash flow. Kenneth Lay, CEO, hired McKinsey & Co. to assist in developing Enron’s business strategy. It assigned a young consultant named Jeffrey Skilling to the engagement. Skilling, who had a background in banking and asset and liability management, proposed a revolutionary solution to Enron’s credit, cash and profit woes in the gas pipeline business: create a “gas bank” in which Enron would buy gas from a network of suppliers and sell it to a network of consumers, contractually guaranteeing both the supply and the price, charging fees for the transactions and assuming the associated risks. Thanks to the young consultant, the company created both a new product and a new paradigm for the industry—the energy derivative.
Lay was so impressed with Skilling’s genius that he created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it. Under Skilling’s leadership, Enron Finance Corp. soon dominated the market for natural gas contracts, with more contacts, more access to supplies and more customers than any of its competitors. With its market power, Enron could predict future prices with great accuracy, thereby guaranteeing superior profits.
THE BEST, THE BRIGHTEST AND THE DREADED PRC
Skilling began to change the corporate culture of Enron to match the company’s transformed image as a trading business. He set out on a quest to hire the best and brightest traders, recruiting associates from the top MBA schools in the country and competing with the largest and most prestigious investment banks for talent. In exchange for grueling schedules, Enron pampered its associates with a long list of corporate perks, including concierge services and a company gym. Skilling rewarded production with merit-based bonuses that had no cap, permitting traders to “eat what they killed.”
One of Skilling’s earliest hires in 1990 was Andrew Fastow, a 29-year-old Kellogg MBA who had been working on leveraged buyouts and other complicated deals at Continental Illinois Bank in Chicago. Fastow became Skilling’s protg in the same way Skilling had become Lay’s. Fastow moved swiftly through the ranks and was promoted to chief financial officer in 1998. As Skilling oversaw the building of the company’s vast trading operation, Fastow oversaw its financing by ever more complicated means.
As Enron’s reputation with the outside world grew, the internal culture apparently began to take a darker tone. Skilling instituted the performance review committee (PRC), which became known as the harshest employee-ranking system in the country. It was known as the “360-degree review” based on the values of Enron—respect, integrity, communication and excellence (RICE). However, associates came to feel that the only real performance measure was the amount of profits they could produce. In order to achieve top ratings, everyone in the organization became instantly motivated to “do deals” and post earnings. Employees were regularly rated on a scale of 1 to 5, with 5s usually being fired within six months. The lower an employee’s PRC score, the closer he or she got to Skilling, and the higher the score, the closer he or she got to being shown the door. Skilling’s division was known for replacing up to 15% of its workforce every year. Fierce internal competition prevailed and immediate gratification was prized above long-term potential. Paranoia flourished and trading contracts began to contain highly restrictive confidentiality clauses. Secrecy became the order of the day for many of the company’s trading contracts, as well as its disclosures.
HOW HIGH THEY FLY
Coincidentally, but not inconsequentially, the U.S. economy during the 1990s was experiencing the longest bull market in its history. Enron’s corporate leadership, Lay excluded, comprised mostly young people who had never experienced an extended bear market. New investment opportunities were opening up everywhere, including markets in energy futures. Wall Street demanded double-digit growth from practically every venture, and Enron was determined to deliver.
In 1996 Skilling became Enron’s chief operating officer. He convinced Lay the gas bank model could be applied to the market for electric energy as well. Skilling and Lay traveled widely across the country, selling the concept to the heads of power companies and to energy regulators. The company became a major political player in the United States, lobbying for deregulation of electric utilities. In 1997 Enron acquired electric utility company Portland General Electric Corp. for about $2 billion. By the end of that year, Skilling had developed the division by then known as Enron Capital and Trade Resources into the nation’s largest wholesale buyer and seller of natural gas and electricity. Revenue grew to $7 billion from $2 billion, and the number of employees in the division skyrocketed to more than 2,000 from 200. Using the same concept that had been so successful with the gas bank, they were ready to create a market for anything that anyone was willing to trade: futures contracts in coal, paper, steel, water and even weather.
Perhaps Enron’s most exciting development in the eyes of the financial world was the creation of Enron Online (EOL) in October 1999. EOL, an electronic commodities trading Web site, was significant for at least two reasons. First, Enron was a counterparty to every transaction conducted on the platform. Traders received extremely valuable information regarding the “long” and “short” parties to each trade as well as the products’ prices in real-time. Second, given that Enron was either a buyer or a seller in every transaction, credit risk management was crucial and Enron’s credit was the cornerstone that gave the energy community the confidence that EOL provided a safe transaction environment. EOL became an overnight success, handling $335 billion in online commodity trades in 2000.
The world of technology opened up the Internet, and the IPO market for technology and broadband communications companies started to take off. In January 2000 Enron announced an ambitious plan to build a high-speed broadband telecommunications network and to trade network capacity, or bandwidth, in the same way it traded electricity or natural gas. In July of that year Enron and Blockbuster announced a deal to provide video on demand to customers throughout the world via high-speed Internet lines. As Enron poured hundreds of millions into broadband with very little return, Wall Street rewarded the strategy with as much as $40 on the stock price—a factor that would have to be discounted later when the broadband bubble burst. In August 2000 Enron’s stock hit an all-time high of $90.56, and the company was being touted by Fortune and other business publications as one of the most admired and innovative companies in the world.
THE ROLE OF MARK-TO-MARKET ACCOUNTING
Enron incorporated “mark-to-market accounting” for the energy trading business in the mid-1990s and used it on an unprecedented scale for its trading transactions. Under mark-to-market rules, whenever companies have outstanding energy-related or other derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealized gains or losses to the income statement of the period. A difficulty with application of these rules in accounting for long-term futures contracts in commodities such as gas is that there are often no quoted prices upon which to base valuations. Companies having these types of derivative instruments are free to develop and use discretionary valuation models based on their own assumptions and methods.
The Financial Accounting Standards Board’s (FASB) emerging issues task force has debated the subject of how to value and disclose energy-related contracts for several years. It has been able to conclude only that a one-size-fits-all approach will not work and that to require companies to disclose all of the assumptions and estimates underlying earnings would produce disclosures that were so voluminous they would be of little value. For a company such as Enron, under continuous pressure to beat earnings estimates, it is possible that valuation estimates might have considerably overstated earnings. Furthermore, unrealized trading gains accounted for slightly more than half of the company’s $1.41 billion reported pretax profit for 2000 and about one-third of its reported pretax profit for 1999.
CAPITALISM AT WORK
In the latter part of the 1990s, companies such as Dynegy, Duke Energy, El Paso and Williams began following Enron’s lead. Enron’s competitive advantage, as well as its huge profit margins, had begun to erode by the end of 2000. Each new market entrant’s successes squeezed Enron’s profit margins further. It ran with increasing leverage, thus becoming more like a hedge fund than a trading company. Meanwhile, energy prices began to fall in the first quarter of 2001 and the world economy headed into a recession, thus dampening energy market volatility and reducing the opportunity for the large, rapid trading gains that had formerly made Enron so profitable. Deals, especially in the finance division, were done at a rapid pace without much regard to whether they aligned with the strategic goals of the company or whether they complied with the company’s risk management policies. As one knowledgeable Enron employee put it: “Good deal vs. bad deal? Didn’t matter. If it had a positive net present value (NPV) it could get done. Sometimes positive NPV didn’t even matter in the name of strategic significance.” Enron’s foundations were developing cracks and Skilling’s house of paper built on the stilts of trust had begun to crumble.
RELATED PARTIES AND COMPLEX SPECIAL PURPOSE ENTITIES
In order to satisfy Moody’s and Standard & Poor’s credit rating agencies, Enron had to make sure the company’s leverage ratios were within acceptable ranges. Fastow continually lobbied the ratings agencies to raise Enron’s credit rating, apparently to no avail. That notwithstanding, there were other ways to lower the company’s debt ratio. Reducing hard assets while earning increasing paper profits served to increase Enron’s return on assets (ROA) and reduce its debt-to-total-assets ratio, making the company more attractive to credit rating agencies and investors.
Enron, like many other companies, used “special purpose entities” (SPEs) to access capital or hedge risk. By using SPEs such as limited partnerships with outside parties, a company is permitted to increase leverage and ROA without having to report debt on its balance sheet. The company contributes hard assets and related debt to an SPE in exchange for an interest. The SPE then borrows large sums of money from a financial institution to purchase assets or conduct other business without the debt or assets showing up on the company’s financial statements. The company can also sell leveraged assets to the SPE and book a profit. To avoid classification of the SPE as a subsidiary (thereby forcing the entity to include the SPE’s financial position and results of operations in its financial statements), FASB guidelines require that only 3% of the SPE be owned by an outside investor.
Under Fastow’s leadership, Enron took the use of SPEs to new heights of complexity and sophistication, capitalizing them with not only a variety of hard assets and liabilities, but also extremely complex derivative financial instruments, its own restricted stock, rights to acquire its stock and related liabilities. As its financial dealings became more complicated, the company apparently also used SPEs to “park” troubled assets that were falling in value, such as certain overseas energy facilities, the broadband operation or stock in companies that had been spun off to the public. Transferring these assets to SPEs meant their losses would be kept off Enron’s books. To compensate partnership investors for downside risk, Enron promised issuance of additional shares of its stock. As the value of the assets in these partnerships fell, Enron began to incur larger and larger obligations to issue its own stock later down the road. Compounding the problem toward the end was the precipitous fall in the value of Enron stock. Enron conducted business through thousands of SPEs. The most controversial of them were LJM Cayman LP and LJM2 Co-Investment LP, run by Fastow himself. From 1999 through July 2001, these entities paid Fastow more than $30 million in management fees, far more than his Enron salary, supposedly with the approval of top management and Enron’s board of directors. In turn, the LJM partnerships invested in another group of SPEs, known as the Raptor vehicles, which were designed in part to hedge an Enron investment in a bankrupt broadband company, Rhythm NetConnections. As part of the capitalization of the Raptor entities, Enron issued common stock in exchange for a note receivable of $1.2 billion. Enron increased notes receivable and shareholders’ equity to reflect this transaction, which appears to violate generally accepted accounting principles. Additionally, Enron failed to consolidate the LJM and Raptor SPEs into their financial statements when subsequent information revealed they should have been consolidated.
OBSCURE DISCLOSURES REVEALED
A very confusing footnote in Enron’s 2000 financial statements described the above transactions. Douglas Carmichael, the Wollman Distinguished Professor of Accounting at Baruch College in New York City, told the Wall Street Journal in November of 2001 that most people would be hard pressed to understand the effects of these disclosures on the financial statements, casting doubt on both the quality of the company’s earnings as well as the business purpose of the transaction. By April 2001 other skeptics arrived on the scene. A number of analysts questioned the lack of transparency of Enron’s disclosures. One analyst was quoted as saying, “The notes just don’t make sense, and we read notes for a living.” Skilling was very quick to reply with arrogant comments and, in one case, even called an analyst a derogatory name. What Skilling and Fastow apparently underestimated was that, because of such actions, the market was beginning to perceive the company with greater and greater skepticism, thus eroding its trust and the company’s reputation.
IT ALL COMES TUMBLING DOWN
In February 2001 Lay announced his retirement and named Skilling president and CEO of Enron. In February Skilling held the company’s annual conference with analysts, bragging that the stock (then valued around $80) should be trading at around $126 per share.
In March Enron and Blockbuster announced the cancellation of their video-on-demand deal. By that time the stock had fallen to the mid-$60s. Throughout the spring and summer, risky deals Enron had made in underperforming investments of various kinds began to unravel, causing it to suffer a huge cash shortfall. Senior management, which had been voting with its feet since August 2000, selling Enron stock in the bull market, continued to exit, collectively hundreds of millions of dollars richer for the experience. On August 14, just six months after being named CEO, Skilling himself resigned, citing “personal reasons.” The stock price slipped below $40 that week and, except for a brief recovery in early October after the sale of Portland General, continued its slide to below $30 a share.
Also in August, in an internal memorandum to Lay, a company vice-president, Sherron Watkins, described her reservations about the lack of disclosure of the substance of the related party transactions with the SPEs run by Fastow. She concluded the memo by stating her fear that the company might “implode under a series of accounting scandals.” Lay notified the company’s attorneys, Vinson & Elkins, as well as the audit partner at Enron’s auditing firm, Arthur Andersen LLP, so the matter could be investigated further. The proverbial “ship” of Enron had struck the iceberg that would eventually sink it.
On October 16 Enron announced its first quarterly loss in more than four years after taking charges of $1 billion on poorly performing businesses. The company terminated the Raptor hedging arrangements which, if they had continued, would have resulted in its issuing 58 million Enron shares to offset the company’s private equity losses, severely diluting earnings. It also disclosed the reversal of the $1.2 billion entry to assets and equities it had made as a result of dealings with these arrangements. It was this disclosure that got the SEC’s attention.
On October 17 the company announced it had changed plan administrators for its employees’ 401(k) pension plan, thus by law locking their investments for a period of 30 days and preventing workers from selling their Enron stock. The company contends this decision had in fact been made months earlier. However true that might be, the timing of the decision certainly has raised suspicions.
On October 22 Enron announced the SEC was looking into the related party transactions between Enron and the partnerships owned by Fastow, who was fired two days later. On November 8 Enron announced a restatement of its financial statements back to 1997 to reflect consolidation of the SPEs it had omitted, as well as to book Andersen’s recommended adjustments from those years, which the company had previously “deemed immaterial.” This restatement resulted in another $591 million in losses over the four years as well as an additional $628 million in liabilities as of the end of 2000. The equity markets immediately reacted to the restatement, driving the stock price to less than $10 a share. One analyst’s report stated the company had burned through $5 billion in cash in 50 days.
A merger agreement with smaller cross-town competitor Dynegy was announced on November 9, but rescinded by Dynegy on November 28 on the basis of Enron’s lack of full disclosure of its off-balance-sheet debt, downgrading Enron’s rating to junk status. On November 30 the stock closed at an astonishing 26 cents a share. The company filed for bankruptcy protection on December 2.
THE AFTERMATH
Unquestionably, the Enron implosion has wreaked more havoc on the accounting profession than any other case in U.S. history. Critics in the media, Congress and elsewhere are calling into question not only the adequacy of U.S. disclosure practices but also the integrity of the independent audit process. The general public still questions how CPA firms can maintain audit independence while at the same time engaging in consulting work, often for fees that dwarf those of the audit. Companies that deal in special purpose entities and complex financial instruments similar to Enron’s have suffered significant declines in their stock prices. The scandal threatens to undermine confidence in financial markets in the United States and abroad.
In a characteristic move, the SEC and the public accounting profession have been among the first to respond to the Enron crisis. Unfortunately, and sadly reminiscent of financial disasters in the 1970s and 1980s, this response will likely be viewed by investors, creditors, lawmakers and employees of Enron as “too little, too late.”
In an “op-ed” piece for the Wall Street Journal on December 11, SEC Chairman Harvey Pitt called the current outdated reporting and financial disclosure system the financial “perfect storm.” He stated that under the current quarterly and annual reporting system, information is often stale on arrival and mandated financial disclosures are often “arcane and impenetrable.” To reassure investors and restore confidence in financial reporting, Pitt called for a joint response from the public and private sectors that included, among other things,
- A system of “current” disclosures, supplementing and updating quarterly and annual information with disclosure of material information on a real-time basis.
- Public company disclosure of significant current “trend” and “evaluative” data in addition to historical information.
- Identification of “most critical accounting principles” by all public companies in their annual reports.
- More timely and responsive accounting standard setting on the part of the private sector.
- An environment of cooperation between the SEC and registrants that encourages public companies and their auditors to seek advice on disclosure issues in advance.
- An effective and transparent system of self-regulation for the accounting profession, subject to SEC’s rigorous, but nonduplicative, oversight.
- More proactive oversight by audit committees who understand financial accounting principles as well as how they are applied.
The CEOs of the Big Five accounting firms made a joint statement on December 4 committing to develop improved guidance on disclosure of related party transactions, SPEs and market risks for derivatives including energy contracts for the 2001 reporting period. In addition, the Big Five called for modernization of the financial reporting system in the United States to make it more timely and relevant, including more nonfinancial information on entity performance. They also vowed to streamline the accounting standard-setting process to make it more responsive to the rapid changes that occur in a technology-driven economy.
Since the Enron debacle, the AICPA has been engaged in significant damage control measures to restore confidence in the profession, displaying the banner “Enron: The AICPA, the Profession, and the Public Interest” on its Web site. It has announced the imminent issuance of an exposure draft on a new audit standard on fraud (the third in five years), providing more specific guidance than currently found in SAS no. 82, Consideration of Fraud in a Financial Statement Audit . The Institute has also promised a revised standard on reviews of quarterly financial statements, as well as the issuance, in the second quarter of 2002, of an exposure draft of a standard to improve the audit process. These standards had already been on the drawing board as part of the AICPA’s response to the report of the Blue Ribbon Panel on Audit Effectiveness, issued in 2000.
In late December the AICPA issued a tool kit for auditors to use in identifying and auditing related party transactions. While it breaks no new ground, the tool kit provides, in one place, an overview of the accounting and auditing literature, SEC requirements and best practice guidance concerning related party transactions. It also includes checklists and other tools for auditors to use in gathering evidence and disclosing related party transactions.
In January the AICPA board of directors announced that it would cooperate fully with the SEC’s proposal for new rules for the peer review and disciplinary process for CPA firms of SEC registrants. The new system would be managed by a board, a majority of which would be public members, enhancing the peer review process for the largest firms and requiring more rigorous and continuous monitoring. The staff of the new board would administer the reviews. In protest, the Public Oversight Board informed Pitt that it would terminate its existence in March 2002, leaving the future peer review process in a state of uncertainty. The SEC and the AICPA are now engaged in talks with the POB to reassure the board it will continue to be a vital part of the peer review process in the future.
The AICPA has also approved a resolution to support prohibitions that would prevent audit firms from performing systems design and implementation as well as internal audit outsourcing for public audit clients. While asserting that it does not believe prohibition of these services will make audits more effective or prevent financial failures, the board has stated it feels the move is necessary to restore public confidence in the profession. These prohibitions were at the center of the controversy last year between the profession and the SEC under the direction of former Chairman Arthur Levitt. Big Five CPA firms and the AICPA lobbied heavily and prevailed in that controversy, winning the right to retain these services and being required only to disclose their fees.
The impact of Enron is now being felt at the highest levels of government as legislators engage in endless debate and accusation, quarreling over the influence of money in politics. The GAO has requested that the White House disclose documents concerning appointments to President George W. Bush’s Task Force on Energy, chaired by Vice-President Dick Cheney, former CEO of Halliburton. The White House has refused, and the GAO has filed suit, the first of its kind in history. Congressional investigations are expected to continue well into 2002 and beyond. Lawmakers are expected to investigate not only disclosure practices at Enron, but for all public companies, concerning SPEs, related party transactions and use of “mark-to-market” accounting.
Kenneth Lay resigned as Enron’s CEO, under pressure from creditor groups. Lay, Skilling and Fastow still have much to explain. In addition, Enron’s board of directors, and especially the audit committee, will be in the “hot seat” and rightfully so.
The Justice Department opened a criminal investigation and formed a national task force made up of federal prosecutors in Houston, San Francisco, New York and several other cities to investigate the possibility of fraud in the company’s dealings. Interestingly, to illustrate how far-reaching Enron’s ties are to government and political sources at all levels, U.S. Attorney General John Ashcroft, as well as his entire Houston office, disqualified themselves from the investigation because of either political, economic or family ties.
It appears that 2002 is shaping up to be a year of unprecedented changes for a profession that is already coping with an identity crisis.
WHERE WERE THE AUDITORS?
Arthur Andersen LLP, after settling two other massive lawsuits earlier in 2001, is preparing for a storm of litigation as well as a possible criminal investigation in the wake of the Enron collapse. Enron was the firm’s second-largest client. Andersen, who had the job not only of Enron’s external but also its internal audits for the years in question, kept a staff on permanent assignment at Enron’s offices. Many of Enron’s internal accountants, CFOs and controllers were former Andersen executives. Because of these relationships, as well as Andersen’s extensive concurrent consulting practice, members of Congress, the press and others are calling Andersen’s audit independence into question. Indeed, they are using the case to raise doubts about the credibility of the audit process for all Big Five firms who do such work.
So far, Andersen has acknowledged its role in the fiasco, while defending its accounting and auditing practices. In a Wall Street Journal editorial on December 4, as well as in testimony before Congress the following week, Joseph Berardino, CEO, was forthright in his views. He committed the firm to full cooperation in the investigations as well as to a leadership role in potential solutions.
Enron dismissed Andersen as its auditor on January 17, 2002, citing document destruction and lack of guidance on accounting policy issues as the reasons. Andersen countered with the contention that in its mind the relationship had terminated on December 2, 2001, the day the firm filed for Chapter 11 bankruptcy protection.
The fact that Andersen is no longer officially associated with Enron will, unfortunately, have little impact on forces now in place that may, in the eyes of some, determine the firm’s very future. Andersen is now under formal investigation by the SEC as well as various committees of both the U.S. Senate and House of Representatives of the U.S. Congress. To make matters worse for it, and to the astonishment of many, Andersen admitted it destroyed perhaps thousands of documents and electronic files related to the engagement, in accordance with “firm policy,” supposedly before the SEC issued a subpoena for them. The firm’s lawyers issued an internal memorandum on October 12 reminding employees of the firm’s document retention and destruction policies. The firm fired David B. Duncan, partner in charge of the Enron engagement, placed four other partners on leave and replaced the entire management team of the Houston office. Duncan invoked his Fifth Amendment rights against self-incrimination at a congressional hearing in January. Several other Andersen partners testified that Duncan and his staff acted in violation of firm policy. However, in view of the timing of the October 12 memorandum, Congress and the press are questioning whether the decision to shred documents extended farther up the chain of command. Andersen has suspended its firm policy for retention of records and asked former U.S. Senator John Danforth to conduct a comprehensive review of the firm’s records management policy and to recommend improvements.
In a move to bolster its image, Andersen also has retained former Federal Reserve Chairman Paul Volcker to lead an outside board that will advise it in making “fundamental change” in its audit process. Other members of the board include P. Roy Vagelos, former chairman and CEO of Merck & Co., and Charles A. Bowsher, current chairman of the Public Oversight Board, which disbanded in March. Volcker also named a seven-member advisory panel made up of prominent corporate and accounting executives that will review proposed reforms to the firm’s audit process.
Hindsight is so clear that it sometimes belies the complexity of the problem. Although fraud has not yet been proven to be a factor in Enron’s misstatements, some of the classic risk factors associated with management fraud outlined in SAS no. 82 are evident in the Enron case. Those include management characteristics, industry conditions and operating characteristics of the company. Although written five years ago, the list almost looks as if it was excerpted from Enron’s case:
- Unduly aggressive earnings targets and management bonus compensation based on those targets.
- Excessive interest by management in maintaining stock price or earnings trend through the use of unusually aggressive accounting practices.
- Management setting unduly aggressive financial targets and expectations for operating personnel.
- Inability to generate sufficient cash flow from operations while reporting earnings and earnings growth.
- Assets, liabilities, revenues or expenses based on significant estimates that involve unusually subjective judgments such as…reliability of financial instruments.
- Significant related party transactions.
These factors are common threads in the tapestry that is described of the environment leading to fraud. They were incorporated into SAS no. 82 on the basis of research into fraud cases of the 1970s and 1980s in the hope that auditors would learn from the past. Andersen will have to explain when and how it identified these factors, as well as how it responded and how it communicated with Enron’s board about them.
More important, Andersen will have to explain why it delayed notifying the SEC after learning of the internal Enron memo warning of problems. In addition, it will have to explain why the Houston office destroyed the thousands of documents related to the Enron audits for 1997 through 2000. Only time will tell, but it appears the firm is in serious trouble. In the end, and also characteristic of cases like this, the chief parties likely to benefit from this process are the attorneys.
THE HUMAN FACTOR
The Enron story has produced many victims, the most tragic of which is a former vice-chairman of the company who committed suicide, apparently in connection with his role in the scandal. Another 4,500 individuals have seen their careers ended abruptly by the reckless acts of a few. Enron’s core values of respect, integrity, communication and excellence stand in satirical contrast to allegations now being made public. Personally, I had referred several of our best and brightest accounting, finance and MBA graduates to Enron, hoping they could gain valuable experience from seeing things done right. These included a very bright training consultant who had lost her job in 2000 with a Houston consulting firm as a result of a reduction in force. She has lost her second job in 18 months through no fault of her own. Other former students still hanging on at Enron face an uncertain future as the company fights for survival.
The old saying goes, “Lessons learned hard are learned best.” Some former Enron employees are embittered by the way they have been treated by the company that was once “the best in the business.” Others disagree. In the words of one of my former students who is still hanging on: “Just for the record, my time and experience at Enron have been nothing short of fantastic. I could not have asked for a better place to be or better people to work with. Please, though, remember this: Never take customer and employee confidence for granted. That confidence is easy to lose and tough—to impossible—to regain.”
C. WILLIAM THOMAS, CPA, Ph.D. , is the J.E. Bush Professor of Accounting in the Hankamer School of Business at Baylor University in Waco. Mr. Thomas can be reached at [email protected] . This article originally appeared in the March/April 2002 issue of Today’s CPA , published by the Texas Society of CPAs.
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The Enron Scandal (2001)
Both of these buildings in downtown Houston, 1400 Smith Street and 1500 Louisiana Street, were formerly occupied by Enron. A ugust 2021 marked the 20 th anniversary of arguably the most notorious corporate-accounting scandal of all time. It may not have been the biggest in dollar terms, or even the most severe in terms of criminality and personnel held culpable, but the Enron Corp. scandal of 2001 remains perhaps the most impactful of all time. One of the largest companies in the United States collapsed virtually overnight, with the fallout of its malfeasance being billions of dollars stolen, thousands of jobs wiped out, dozens of criminal convictions and even one incident of suicide.
Indeed, when Enron filed for bankruptcy protection on December 2, 2001, it was the largest company to do so in US history until that point in time. It was also once the world’s largest energy-trading company, with a market value of up to $68 billion, before its collapse destroyed thousands of jobs and more than $2 billion in pension plans. The shockwaves the scandal sent across capital markets were seismic, shaking investor confidence to its core and changing the corporate and regulatory landscapes forever.
Jeffrey Keith Skilling was CEO of Enron Corporation at the time of the Enron scandal.
Enron was born in 1985 as a result of the merger between Houston Natural Gas Company and InterNorth Inc., with the chief executive officer (CEO) of Houston, Kenneth Lay, taking the reins of the newly formed entity. By 1990, Lay had hired Jeffrey K. (Jeff) Skilling, a partner at consulting firm McKinsey, which at the time was advising Enron. Two years later, Skilling had created a new accounting technique called mark-to-market (MTM) accounting, which was granted formal approval by the U.S. Securities and Exchange Commission (SEC) in 1992.
MTM accounting enables a company to adjust the value of its balance-sheet assets from their historical value to the current fair market value (FMV), and thus means that income can be calculated as an estimate of the present value of net future cash flow. Should a contract be worth $100 million over the coming 10 years, for instance, MTM accounting would enable a company to write $100 million in its books on the day the contract was signed, irrespective of whether the deal ultimately matched expectations. As such, Enron was able to inflate its present-day worth through its financial statements, substantially over and above what it had actually earned, and thus obfuscate the truth about its business performance.
This was perhaps no more clearly illustrated than when Enron Broadband Services, a subsidiary of Enron, partnered with Blockbuster in July 2000 in a 20-year deal to sell movie-on-demand services through its broadband network. In the pre-Netflix era, the prospect of delivering movies to people’s computers or televisions via broadband was a new and exciting one. And using MTM accounting meant that Enron could book all 20 years of forward projections from the deal—in this case, $110 million of estimated profit—to its financial statements for the mid-year 2000.
But the partnership ended up being terminated after movie studios expressed their opposition to Blockbuster providing such services. The failed deal and Blockbuster’s withdrawal, however, did not stop Enron from continuing to claim future profits and thus sell shares of the company at hugely inflated prices, despite the deal resulting in a loss. Arguably, this was the first major incident to kick off the external scrutiny into Enron’s dealings and its questionable MTM practices.
Eventually, the unit CEO, Joseph Hirko, and vice presidents F. Scott Yeager and Rex Shelby were charged with conspiracy, fraud, insider trading and money laundering related to those practices. And Kevin Howard, the former chief financial officer (CFO), and Michael W. Krautz, a former senior director of accounting, of Enron Broadband Services were charged with conspiracy and fraud tied to the fabrication of earnings stemming from the failed Blockbuster deal.
The company also used accounting tricks to misclassify loan transactions as revenues just before quarterly financial-reporting dates. For instance, they entered into a deal with Merrill Lynch in which the US bank bought Nigerian barges with a buyback guarantee from Enron just before its earnings deadline. Enron misreported this bridge loan as a true sale before buying the barges back a few months later. Merrill Lynch was eventually held culpable in November for its role in assisting Enron in its accounting fraud, with some of the bank’s executives spending almost a year in prison.
Special purpose entities (SPEs) played a significant role in Enron’s misdeeds. Dubbed as the “Raptors”, these SPEs were created by the company—specifically by CFO Andrew Fastow with the apparent blessing of Skilling, Lay and the board of directors—to protect itself against MTM losses from its equity investments. Once these stocks began performing poorly, Enron “sold” them into the Raptors—LJM Cayman. L.P. (LJM1) and LJM2 Co-Investment L.P. (LJM2)—to shore up the appearance of its financial statements. In other words, LJM1 and LJM2 were created purely for the purpose of acting as the external equity investor required for the SPEs being used by Enron.
Fastow stated much of this when he testified before the U.S. Congress in the aftermath of the scandal and also confirmed that he himself stood to “benefit greatly from the partnerships”; indeed, he ended up pocketing some $45 million in the profit from his activity. In January 2004, he pleaded guilty to two counts of fraud, agreed to a prison term of up to 10 years and forfeited $24 million. “I was being a hero for Enron,” he said repeatedly during the testimony. “We were using this to inflate our earnings.”
According to the US government, Enron’s board also approved moving an affiliated company, Whitewing, off the books while guaranteeing its debt with $1.4 billion in Enron’s stock and helping it obtain funding to purchase Enron’s assets. “From the Raptor transactions, and numerous others described in the Powers Report, Congressional testimony, and newspaper reports, Enron may have paid out well over $300 million—in the form of cash, investments, and Enron stock—to advisors and SPE equity holders in order to sustain its network of off–balance sheet financing entities,” noted The CPA Journal in 2003. “By comparison, the Financial Accounting Foundation spent just $22 million to generate and maintain its FASB [Financial Accounting Standards Board] and GASB [Government Accounting Standards Board] standards-setting programs. As a result, it is not difficult to see how determined companies can run rings around GAAP [generally accepted accounting principles], exploiting technicalities and loopholes to create financial statements that even the most sophisticated investors cannot understand.”
In terms of Enron’s path towards bankruptcy, the failed Blockbuster deal kicked off a gradually expanding wave of scrutiny into the company’s accounts from the financial press. The Texas Journal ran a story in September 2000 about the shortfalls and lack of transparency surrounding the MTM accounting techniques being increasingly adopted by the energy industry. The following March, the Fortune article “Is Enron Overpriced?” questioned the company’s stock valuation and posited that investors were unaware of how exactly Enron made money, while concerns voiced by the article’s author, Bethany McLean, were dismissed by Skilling when she tried to discuss her findings with him before publishing the article. And perhaps most infamously, on a conference call with Wall Street analyst Richard Grubman who pressed him into explaining more about Enron’s accounting practices, Skilling retorted, “Well uh…. Thank you very much, we appreciate it…. Asshole.” The response was met with considerable astonishment from the public.
By late October, following mounting complaints from analysts over the opacity of Enron’s financial statements, ratings agency Moody’s had lowered Enron’s credit rating to just two levels above junk status. A few days later, it was revealed to the public that the SEC had begun a formal investigation into Enron and its dealings with “related parties”.
By late November 2001, Enron’s stock price had plunged to less than $1 per share, in stark contrast to its mid-2000 peak of $90.75. The company was estimated to have $23 billion in liabilities from both outstanding debts and guaranteed loans, raising speculation that it would have to declare bankruptcy. Enron Europe, the holding company for Enron’s operations in Continental Europe, was the first to do so on November 30, a day before the board voted unanimously to file for Chapter 11 protection for the rest of the company.
At $63.4 billion in total assets, Enron’s was the largest corporate bankruptcy in US history until the WorldCom scandal just one year later. Around 4,000 jobs were lost, and almost two-thirds of the 15,000 employees’ savings plans that depended on Enron stock, which had been purchased at $83 at the start of the year, became worthless.
Additional fallout from the scandal was most directly suffered by Enron’s accounting firm, Arthur Andersen, which earned $52 million in audit and consulting fees in 2000, more than one-quarter of total audit fees generated by the company’s Houston office clients. Andersen was accused of failing to apply sufficient standards during its audits of Enron’s books and conducting itself in a way to simply receive its fees without sufficiently examining Enron’s accounting practices.
“When confronted by evidence of Enron’s high-risk accounting, all of the Board members interviewed by the Subcommittee pointed out that Enron’s auditor, Andersen, had given the company a clean audit opinion each year,” the US Senate found . “None recalled any occasion on which Andersen had expressed any objection to a particular transaction or accounting practice at Enron, despite evidence indicating that, internally at Andersen, concerns about Enron’s accounting were commonplace. But a failure by Andersen to object does not preclude a finding that the Enron Board, with Andersen’s concurrence, knowingly allowed Enron to use high risk accounting and failed in its fiduciary duty to ensure the company engaged in responsible financial reporting.”
Sherron Watkins (left), Vice President of Corporate Development for the Enron Corporation, Skilling attorney Bruce Hiler (middle), and Jeffrey Skilling (right), former CEO of Enron, during the Senate Commerce hearing on the company’s bankruptcy | Photo Credit: Ferrell, Scott J – Library of Congress
It was eventually revealed that several conflicts of interest arose between Andersen and Enron. For example, Andersen’s Houston office, which conducted the audits, had the power to overrule any criticism levelled at Enron’s accounting practices by Andersen’s Chicago partner. It was also discovered that Enron’s management had applied considerable pressure on Andersen’s auditors to meet its earnings expectations. For instance, it would briefly hire other accounting companies to conduct some accounting tasks and thus give the impression that it would replace Andersen. The shredding of almost 30,000 e-mails and other files after Enron’s malpractice was made public also raised suspicion of widespread collusion between the two parties.
Ultimately, Andersen’s involvement with Enron caused the accounting firm to break up, again leading to thousands of job losses. “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,” according to the (William C.) Powers Committee, which was appointed by Enron’s board to review its accounting practices in October 2001.
The 2002 enactment of the Sarbanes-Oxley Act did strengthen the oversight of accountants; reduced the potential for conflicts of interests faced by auditors, specifically by barring them from providing various consulting services to audit clients; and enhanced the SEC’s enforcement tools.
But it wasn’t until February 2004 that the SEC finally indicted Skilling, charging him with “violating, and aiding and abetting violations of, the antifraud, lying to auditors, periodic reporting, books and records, and internal controls provisions of the federal securities laws”.
“In this scandal, as in others, we are by now all too familiar with executives who bask in the attention that follows the appearance of corporate success, but who then shout their ignorance when the appearance gives way to the reality of corruption,” Stephen M. Cutler, director of the SEC’s Enforcement Division, said at the time. “Let there be no mistake that today’s enforcement action against Mr. Skilling places accountability exactly where it belongs.”
A federal jury in 2006 convicted him on 19 out of 28 criminal counts, including fraud, conspiracy and insider trading. He was sentenced to 24 years in prison and ordered to forfeit $45 million. Lay was convicted of all six counts of securities and wire fraud for which he had been tried, but he died in July 2006 before serving his sentence of potentially up to 45 years behind bars.
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- DOJ Archive
Press Release: Federal Jury Convicts Former Enron Chief Executives Ken Lay, Jeff Skilling on Fraud, Conspiracy and Related Charges (05-25-06)
Transcript of Statement by Deputy Attorney General Paul J. McNulty on the Convictions of Former Enron Chief Executive Officers Ken Lay and Jeff Skilling (05-25-06) (PDF)
Former Enron Chief Accounting Officer Richard Causey Pleads Guilty to Securities Fraud (12-28-05)
Former Enron Chairman and Chief Executive Officer Kenneth L. Lay Charged with Conspiracy, Fraud, False Statement (7-7-04)
Former Enron Chief Executive Officer Jeffrey K. Skilling Charged with Conspiracy, Securities Fraud, Insider Trading (2-19-04)
U.S. vs Kenneth L. Lay Verdict Slip (PDF)
U.S. vs Jeffrey K. Skilling Verdict Slip (PDF)
List of Witnesses (PDF)
May 23, 2006 Demos May 23, 2006 May 22, 2006 Part 1 May 22, 2006 Part 2 May 18, 2006 Part 1 May 18, 2006 Part 2 May 18, 2006 Part 3
May 3, 2006 May 2, 2006 May 1, 2006 April 27, 2006 April 26, 2006 April 20, 2006 April 19, 2006 April 18, 2006 April 17, 2006 April 10, 2006 April 6, 2006 April 3, 2006 March 28, 2006 part 1 March 28, 2006 part 2 March 28, 2006 part 3 March 27, 2006 March 22, 2006 March 21, 2006 March 20, 2006 March 15, 2006 March 14, 2006 March 8, 2006 March 7, 2006 March 6, 2006 March 2, 2006 February 28, 2006 February 27, 2006 February 22, 2006 February 21, 2006 February 16, 2006 February 14, 2006 February 13, 2006 February 6, 2006 February 2, 2006 February 1, 2006
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