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ENRON SCANDAL

Updated: Jun 19, 2023

The study of corporate governance is incomplete without studying the Enron scandal, which is said to be the largest corporate scandal in US history. The scandal also has a book to its name “The Smartest Guys In The Room”, authored by Bethany McLean and Peter Elkind, which was later even adapted into an American documentary film. The scam highlights how an accounting and audit failure led to the company’s bankruptcy and permanently imprinted its name into the bad books of corporate governance.


Background

Enron Corporation was formed in 1985 and was based in Houston, Texas. The company was a result of a merger between Houston Natural Gas Co. and Omaha, Nebraska-based InterNorth Inc, which were pipeline business giants. After the formation of Enron, the CEO of Houston Natural Gas, Kenneth Lay, became the CEO and Chairman of Enron. During the same time, the natural gas industry in the USA was deregulated and seeing this as an opportunity to capitalise, Lay rebranded Enron into an energy trader and supplier to wholesale and retail clients. Enron transported natural gas through pipelines all over the United States for its customers. It also provided services related to electricity and broadband. EnronOnline (EOL), an electronic trading website was created in 1999 to trade in commodities and Enron was a party to every transaction. It offered its reputation, credit and expertise in the energy sector.


In 1990, Mckinsey & Co. consultant Jeffrey Skilling was appointed to head Enron Finance Corporation. He appointed Andrew Fastow in the role of CFO. Lay along with Skilling and Fastow drove the company’s operations and expansions and helped it reach the peak of its success.

It soon became a corporate giant and Wall Street favourite. It enjoyed immense fame from 1998-2001 as it rose to great financial heights. It became a $150 billion energy company. Fortune named Enron as America’s most innovative company for six consecutive years from 1996-2001. It became the seventh-largest company in America during that period.

The collapse of Enron after achieving such heights was shocking for everyone around. Below is an analysis of factors and wrongdoings that led to the company’s downfall.

ENRON SCANDAL

Work culture in Enron

Enron’s ambitious targets and its belief in its supremacy were strongly communicated to its employees, who were expected to contribute extraordinarily to the company’s success. Employees were driven by the company’s agenda of profits at any cost. Skilling created a system to knock out the 20 per cent workforce who performed the lowest according to his rating threshold every six months. In order to adapt to such a work culture, employees who were under constant pressure to deliver, sacrificed ethics at many points in their deliverables.


Bankruptcy in 2001

Shockingly, Enron filed for bankruptcy in 2001, which was the largest bankruptcy in the US.


What went wrong?

Simply it can be said that greed to earn more and more profits in unethical and unacceptable ways led to the conglomerate’s disastrous end.


Painted a false financial picture

Using its fame and growth, Enron attracted investors and trading partners to fuel its growth expectations. The executive management committee of Enron violated the accounting regulations under GAAP (Generally Accepted Accounting Principles) to cover up its true financial situation. It resorted to deceptive means such as:

A. Manipulation of balance sheet

The balance sheet of a company directly affects the stock price on the exchange. And it was thus constantly manipulated to increase the value of its stock price.

B. Use of SPVs (Special Purpose Vehicles)

SPVs were used as a medium to conceal huge debts and toxic assets. A special purpose entity is a subsidiary or a side company created by the parent company to hide its liabilities and isolate financial risk. They are off-the-books corporations where inputs would go unreported. So, a number of such entities were created to push off its debts and losses.

The transfer of stocks in return for cash or notes to these SPVs were facilitated. These stocks would then be utilised by SPVs to hedge an asset on Enron’s balance sheet. The company’s CFO Fastow highlighted that the strategy to use SPV was intended to showcase a continuous cash flow against sold assets in the books of Enron. It misrepresented the company’s financial condition to dupe investors to invest in the company.

C. Collusion with banks, lawyers and auditors

They conspired with Citigroup bank, JP Morgan Chase, law firm Vinson & Elkins and auditor Arthur Anderson for almost eight years to fool investors by falsely implicating loans as cash flows and creating SPVs. Such a fraud would not have been possible, had the above entities not assisted Enron. For example, none of the special purpose partnerships would have been formed if the law firm would not have furnished opinion letters to Enron.

D. Mark To Market

Mark to market or MTM is a method to assess the fair value of assets and liabilities subject to the current market conditions. It can fluctuate values on both sides of a balance sheet carrying the potential to change its face. So Enron built a power plant in India and it mentioned its profits in the financial statement based on MTM, whereas in reality at the time of mentioning such profits, it had not earned even a single penny. Similarly, they also entered expected growth figures in their financial statement after Enron broadband services in 2000 entered into a partnership with Blockbuster, a huge video rental chain. This kind of practice can mislead investors who are carried away by the sight of profitable numbers in financial statements. Not many know that these inflated figures are not real profits but only future speculations based on uncertain market conditions. It is a technique to make a company appear profitable. If the revenue generated was less than the projected profits, it would shift it to an SPV rather than disclosing the figure as losses on its balance sheet.

E. Hiding behind derivatives

Enron hid losses in derivatives by presenting loans in the form of prepaid commodity swaps.

F. Covering debts with its stocks

When partnerships failed, debts were created. The company tried to cover the debt with its own stocks. However, after Enron’s stock price was starting to decline, this arrangement started to backfire because the company started to fall short of cash.

G. Revelation of the true financial picture

Enron’s financial statement, which was a positive sum of $127 million in 2000 turned to a negative sum of $753 million in 2001 after the wrongdoings came to light and a true assessment of the balance sheet took place. Its stockholder equity fell by $1.2 billion.


The role of the CFO

Fastow played a leading role in concealing $1 billion debt and inflating Enron’s profits. He illegally earned around $30 million as personal illicit gains.

He was convicted by the US Justice Department for fraud, conspiracy, money laundering and obstruction of justice. He was sentenced to 6 years in jail and was levied a heavy penalty. The officials also recovered $30 million which Fastow earned in an illegal manner. He also agreed to cooperate with the investigators and serve as a witness against Skilling and Lay.


The role of the CEO

Skilling was the mastermind of Enron. He was very well aware of Enron’s off-balance-sheet partnerships but he consciously decided to ignore the wrongdoings; this led to the liquidity crisis at Enron and its bankruptcy. He was sentenced to imprisonment for 14 years.


The role of the Chairman

Lay confessed that he was part of board meetings that permitted off-balance-sheet partnerships. But he pleaded his innocence by saying that he was not aware of the illegality of such partnerships, given that they had received a green signal from lawyers and accountants. However, he was also engaged in suspicious activities like insider trading, where after he could foresee the storm that would come on Enron, decided to sell his $80 million stocks in parts. Whereas on the other hand, he encouraged employees to buy more stocks. He, however, died due to heart failure before the arrival of his guilty verdict. He was convicted of fraud, conspiracy and insider trading.


The role of Arthur Anderson

The role of an auditor is to ensure the accuracy of financial statements and bookkeeping. And investors rely on and take decisions based on the auditor’s report of a company’s financial status. In addition to being the auditor firm of Enron, Arthur Anderson also stepped into the shoes of a consultant. The accounting practices of Anderson in Enron were questioned as they failed or deliberately assisted Enron to cover up the financial losses and debts. An important observation, which was noted here was that Anderson apparently aided Enron to falsify its finances because a significant chunk of Anderson’s revenue, approx. 28% at the Houston office came from Enron as it was in its top clientele.


Consequences of the Enron scam

The scam not only brought down a massive company but destroyed the dreams of thousands of its employees, rendering them jobless. The stock price was running at $90.75 on 02, December 2001. After the revelation of the scam, Enron was trading at $0.26. Investors lost billions. They lost nearly $11 billion. Their trust and confidence were deeply shattered. Stringent regulations like the Sarbanes-Oxley Act were introduced to raise the standards of corporate governance. Investors turned a blind eye towards companies that were audited by Arthur Anderson.


Conclusion

The Enron scandal highlights the fact that an aggressive corporate culture that sacrifices business ethics to elevate its game at the stock exchange is bound to fall. Principles and business ethics play a crucial role in the success and reputation of any organisation. Laws and regulations still leave a grey area for manipulating actions but adhering to business ethics can never go wrong.



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