Enron Scandal: The Fall of a Wall Street

Darling
The story of Enron Corporation depicts a company that reached dramatic
heights only to face a dizzying fall. The fated company's collapse affected
thousands of employees and shook Wall Street to its core. At Enron's peak, its
shares were worth $90.75; when the firm declared bankruptcy on December
2, 2001, they were trading at $0.26. To this day, many wonder how such a
powerful business, at the time one of the largest companies in the United
States, disintegrated almost overnight. Also difficult to fathom is how its
leadership managed to fool regulators for so long with fake holdings and off-
the-books accounting. 

Enron's Energy Origins

Enron was formed in 1985 following a merger between Houston Natural Gas
Company and Omaha-based InterNorth Incorporated. Following the merger,
Kenneth Lay, who had been the chief executive officer (CEO) of Houston
Natural Gas, became Enron's CEO and chairman. Lay quickly rebranded
Enron into an energy trader and supplier. Deregulation of the energy markets
allowed companies to place bets on future prices, and Enron was poised to
take advantage. In 1990, Lay created the Enron Finance Corporation and
appointed Jeffrey Skilling, whose work as a McKinsey & Company consultant
had impressed Lay, to head the new corporation. Skilling was then one of the
youngest partners at McKinsey. 
Skilling joined Enron at an auspicious time. The era's minimal regulatory
environment allowed Enron to flourish. At the end of the 1990s, the dot-com
bubble was in full swing, and the Nasdaq hit 5,000. Revolutionary internet
stocks were being valued at preposterous levels and, consequently, most
investors and regulators simply accepted spiking share prices as the new
normal.
KEY TAKEAWAYS

 Enron's leadership fooled regulators with fake holdings and off-the-

books accounting practices.
 Enron used special purpose vehicles (SPVs), or special purposes
entities (SPEs), to hide its mountains of debt and toxic assets from
investors and creditors.
 The price of Enron's shares went from $90.75 at its peak to $0.26 at
bankruptcy.
 The company paid its creditors more than $21.7 billion from 2004 to
2011.
Mark-to-Market
One of Skilling's early contributions was to transition Enron's accounting from
a traditional historical cost accounting method to mark-to-market (MTM)
accounting method, for which the company received official SEC approval in
1992. MTM is a measure of the fair value of accounts that can change over
time, such as assets and liabilities. Mark-to-market aims to provide a realistic
appraisal of an institution's or company's current financial situation, and it is a
legitimate and widely used practice. However, in some cases, the method can
be manipulated, since MTM is not based on "actual" cost but on "fair value,"
which is harder to pin down. Some believe MTM was the beginning of the end
for Enron as it essentially permitted the organization to log estimated profits as
actual profits.

Enron Hailed for Its Innovation

Enron created Enron Online (EOL) in October 1999, an electronic trading
website that focused on commodities. Enron was the counterparty to every
transaction on EOL; it was either the buyer or the seller. To entice participants
and trading partners, Enron offered its reputation, credit, and expertise in the
energy sector. Enron was praised for its expansions and ambitious projects,
and it was named "America's Most Innovative Company" by Fortune for six
consecutive years between 1996 and 2001.

Blockbuster Video's Role

One of the many unwitting players in the Enron scandal was Blockbuster, the
former juggernaut video rental chain. In July 2000, Enron Broadband Services
and Blockbuster entered a partnership to enter the burgeoning VOD market.
The VOD market was a sensible pick, but Enron started logging expected
earnings based on the expected growth of the VOD market, which vastly
inflated the numbers.

By mid-2000, EOL was executing nearly $350 billion in trades. When the dot-
com bubble began to burst, Enron decided to build high-speed broadband
telecom networks. Hundreds of millions of dollars were spent on this project,
but the company ended up realizing almost no return.

When the recession hit in 2000, Enron had significant exposure to the most
volatile parts of the market. As a result, many trusting investors and creditors
found themselves on the losing end of a vanishing market cap.

The Wall Street Darling Crumbles

By the fall of 2000, Enron was starting to crumble under its own weight. CEO
Jeffrey Skilling hid the financial losses of the trading business and other
operations of the company using mark-to-market accounting. This technique
measures the value of a security based on its current market value instead of
its book value. This can work well when trading securities, but it can be
disastrous for actual businesses.

In Enron's case, the company would build an asset, such as a power plant,
and immediately claim the projected profit on its books, even though the
company had not made one dime from the asset. If the revenue from the
power plant was less than the projected amount, instead of taking the loss, the
company would then transfer the asset to an off-the-books corporation where
the loss would go unreported. This type of accounting enabled Enron to write
off unprofitable activities without hurting its bottom line.

The mark-to-market practice led to schemes that were designed to hide the
losses and make the company appear more profitable than it really was. To
cope with the mounting liabilities, Andrew Fastow, a rising star who was
promoted to chief financial officer in 1998, developed a deliberate plan to
show that the company was in sound financial shape despite the fact that
many of its subsidiaries were losing money.

How Did Enron Hide Its Debt?

Fastow and others at Enron orchestrated a scheme to use off-balance-
sheet special purpose vehicles (SPVs), also known as special purposes
entities (SPEs), to hide its mountains of debt and toxic assets from investors
and creditors. The primary aim of these SPVs was to hide accounting realities
rather than operating results.

The standard Enron-to-SPV transaction would be the following: Enron would

transfer some of its rapidly rising stock to the SPV in exchange for cash or a
note. The SPV would subsequently use the stock to hedge an asset listed on
Enron's balance sheet. In turn, Enron would guarantee the SPV's value to
reduce apparent counter

party risk.

Although their aim was to hide accounting realities, the SPVs were not illegal.
But they were different from standard debt securitization in several significant
—and potentially disastrous—ways. One major difference was that the SPVs
were capitalized entirely with Enron stock. This directly compromised the
ability of the SPVs to hedge if Enron's share prices fell. Just as dangerous as
the second significant difference: Enron's failure to disclose conflicts of
interest. Enron disclosed the SPVs' existence to the investing public—
although it's certainly likely that few people understood them—it failed to
adequately disclose the non-arm's-length deals between the company and the
SPVs.

Enron believed that their stock price would continue to appreciate—a belief
similar to that embodied by Long-Term Capital Management, a large hedge
fund, before its collapse in 1998. Eventually, Enron's stock declined. The
values of the SPVs also fell, forcing Enron's guarantees to take effect. 
Arthur Andersen and Enron
In addition to Andrew Fastow, a major player in the Enron scandal was
Enron's accounting firm Arthur Andersen LLP and partner David B. Duncan,
who oversaw Enron's accounts. As one of the five largest accounting firms in
the United States at the time, Andersen had a reputation for high standards
and quality risk management.

However, despite Enron's poor accounting practices, Arthur Andersen offered

its stamp of approval, signing off on the corporate reports for years. By April
2001, many analysts started to question Enron's earnings and the
company's transparency.

The Shock Felt Around Wall Street

By the summer of 2001, Enron was in freefall. CEO Kenneth Lay had retired in
February, turning over the position to Jeffrey Skilling. In August 2001, Skilling
resigned as CEO citing personal reasons. Around the same time, analysts
began to downgrade their rating for Enron's stock, and the stock descended to
a 52-week low of $39.95. By October 16, the company reported its first
quarterly loss and closed its "Raptor" SPV so that it would not have to
distribute 58 million shares of stock, which would further reduce earnings. This
action caught the attention of the SEC.

A few days later, Enron changed pension plan administrators, essentially

forbidding employees from selling their shares for at least 30 days. Shortly
after, the SEC announced it was investigating Enron and the SPVs created by
Fastow. Fastow was fired from the company that day. Also, the company
restated earnings going back to 1997. Enron had losses of $591 million and
had $628 million in debt by the end of 2000. The final blow was dealt when
Dynegy (NYSE: DYN), a company that had previously announced would
merge with Enron, backed out of the deal on November 28. By December 2,
2001, Enron had filed for bankruptcy.

$74 billion
The amount that shareholders lost in the four years leading up to Enron's
bankruptcy.
Bankruptcy
Once Enron's Plan of Reorganization was approved by the U.S. Bankruptcy
Court, the new board of directors changed Enron's name to Enron Creditors
Recovery Corporation (ECRC). The company's new sole mission was "to
reorganize and liquidate certain of the operations and assets of the 'pre-
bankruptcy' Enron for the benefit of creditors." The company paid its creditors
more than $21.7 billion from 2004 to 2011. Its last payout was in May 2011.

Criminal Charges
Arthur Andersen was one of the first casualties of Enron's notorious demise. In
June 2002, the firm was found guilty of obstructing justice for shredding
Enron's financial documents to conceal them from the SEC. The conviction
was overturned later, on appeal; however, the firm was deeply disgraced by
the scandal and dwindled into a holding company. A group of former partners
bought the name in 2014, creating a firm named Andersen Global.

Several of Enron's executives were charged with conspiracy, insider trading,

and securities fraud. Enron's founder and former CEO Kenneth Lay were
convicted on six counts of fraud and conspiracy and four counts of bank fraud.
Prior to sentencing, he died of a heart attack in Colorado.

Enron's former star CFO Andrew Fastow pled guilty to two counts of wire
fraud and securities fraud for facilitating Enron's corrupt business practices.
He ultimately cut a deal for cooperating with federal authorities and served
more than five years in prison. He was released from prison in 2011.

Ultimately, former Enron CEO Jeffrey Skilling received the harshest sentence

of anyone involved in the Enron scandal. In 2006, Skilling was convicted of
conspiracy, fraud, and insider trading. Skilling originally received a 24-year
sentence, but in 2013 it was reduced by 10 years. As a part of the new deal,
Skilling was required to give $42 million to the victims of the Enron fraud and
to cease challenging his conviction. Skilling remains in prison and is
scheduled for release on February 21, 2028.

New Regulations After Scandal

Enron's collapse and the financial havoc it wreaked on its shareholders and
employees led to new regulations and legislation to promote the accuracy of
financial reporting for publicly held companies. In July 2002, President George
W. Bush signed into law the Sarbanes-Oxley Act. The Act heightened the
consequences for destroying, altering, or fabricating financial statements, and
for trying to defraud shareholders.

 
As one researcher states, the Sarbanes-Oxley Act is a "mirror image of Enron:
the company's perceived corporate governance failings are matched virtually
point for point in the principal provisions of the Act." (Deakin and Konzelmann,
2003). 

The Enron scandal resulted in other new compliance measures. Additionally,

the Financial Accounting Standards Board (FASB) substantially raised its
levels of ethical conduct. Moreover, company boards of directors became
more independent, monitoring the audit companies, and quickly replacing poor
managers. These new measures are important mechanisms to spot and close
loopholes that companies have used to avoid accountability.
Criminal Charges
Arthur Andersen was one of the first casualties of Enron's notorious demise. In
June 2002, the firm was found guilty of obstructing justice for shredding
Enron's financial documents to conceal them from the SEC. The conviction
was overturned later, on appeal; however, the firm was deeply disgraced by
the scandal and dwindled into a holding company. A group of former partners
bought the name in 2014, creating a firm named Andersen Global.

Several of Enron's executives were charged with conspiracy, insider trading,

and securities fraud. Enron's founder and former CEO Kenneth Lay were
convicted on six counts of fraud and conspiracy and four counts of bank fraud.
Prior to sentencing, he died of a heart attack in Colorado.

Enron's former star CFO Andrew Fastow pled guilty to two counts of wire
fraud and securities fraud for facilitating Enron's corrupt business practices.
He ultimately cut a deal for cooperating with federal authorities and served
more than five years in prison. He was released from prison in 2011.

Ultimately, former Enron CEO Jeffrey Skilling received the harshest sentence

of anyone involved in the Enron scandal. In 2006, Skilling was convicted of
conspiracy, fraud, and insider trading. Skilling originally received a 24-year
sentence, but in 2013 it was reduced by 10 years. As a part of the new deal,
Skilling was required to give $42 million to the victims of the Enron fraud and
to cease challenging his conviction. Skilling remains in prison and is
scheduled for release on February 21, 2028.

New Regulations After Scandal

Enron's collapse and the financial havoc it wreaked on its shareholders and
employees led to new regulations and legislation to promote the accuracy of
financial reporting for publicly held companies. In July 2002, President George
W. Bush signed into law the Sarbanes-Oxley Act. The Act heightened the
consequences for destroying, altering, or fabricating financial statements, and
for trying to defraud shareholders.

 
As one researcher states, the Sarbanes-Oxley Act is a "mirror image of Enron:
the company's perceived corporate governance failings are matched virtually
point for point in the principal provisions of the Act." (Deakin and Konzelmann,
2003). 

The Enron scandal resulted in other new compliance measures. Additionally,

the Financial Accounting Standards Board (FASB) substantially raised its
levels of ethical conduct. Moreover, company boards of directors became
more independent, monitoring the audit companies, and quickly replacing poor
managers. These new measures are important mechanisms to spot and close
loopholes that companies have used to avoid accountability.