Enron Scandal: The Fall of a Wall Street Darling

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

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

"America's Most Innovative Company"

Enron was formed in 1985, following a merger between Houston Natural Gas Co. and Omaha-
based InterNorth Inc. Following the merger, Kenneth Lay, who had been the chief executive
officer (CEO) of Houston Natural Gas, became Enron's CEO and chairman and quickly
rebranded Enron into an energy trader and supplier. Deregulation of the energy markets
allowed companies to place bets on future prices, and Enron was poised to take advantage.

The era's regulatory environment also allowed Enron to flourish. At the end of the 1990s,
the dot-com bubble was in full swing, and the Nasdaq hit 5,000. Revolutionary
internet stocks were being valued at preposterous levels and consequently, most investors and
regulators simply accepted spiking share prices as the new normal.

Enron participated by creating Enron Online (EOL) in October 1999, an

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

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

When the recession hit in 2000, Enron had significant exposure to the most volatile parts of the
market. As a result, many trusting investors and creditors found themselves on the losing end of
a vanishing market cap.
The Collapse of a Wall Street Darling
By the fall of 2000, Enron was starting to crumble under its own weight. CEO Jeffrey Skilling
had a way of hiding the financial losses of the trading business and other operations of the
company; it was called mark-to-market accounting. This is a technique used where you
measure the value of a security based on its current market value, instead of its book value.
This can work well when trading securities, but it can be disastrous for actual businesses.

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

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

How Did Enron Use SPVs to Hide its Debt?

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

The standard Enron-to-SPV transaction would go like this: Enron would transfer some of its
rapidly rising stock to the SPV in exchange for cash or a note. The SPV would subsequently use
the stock to hedge an asset listed on Enron's balance sheet. In turn, Enron would guarantee the
SPV's value to reduce apparent counterparty risk.

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

Enron believed that its stock price would keep appreciating — a belief similar to that embodied
by Long-Term Capital Management, a large hedge fund, before its collapse in 1998. Eventually,
Enron's stock declined. The values of the SPVs also fell, forcing Enron's guarantees to take
effect.

Arthur Andersen and Enron: Risky Business

In addition to Andrew Fastow, a major player in the Enron scandal was Enron's accounting firm
Arthur Andersen LLP and partner David B. Duncan, who oversaw Enron's accounts. As one of
the five largest accounting firms in the United States at the time, Andersen had a reputation for
high standards and quality risk management.

However, despite Enron's poor accounting practices, Arthur Andersen offered its stamp of
approval, signing off on the corporate reports for years – which was enough for investors and
regulators alike. This game couldn't go on forever, however, and by April 2001,
many analysts started to question Enron's earnings and their transparency.

The Shock Felt Around Wall Street

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

A few days later, Enron changed pension plan administrators, essentially forbidding employees
from selling their shares, for at least 30 days. Shortly after, the SEC announced it was
investigating Enron and the SPVs created by Fastow. Fastow was fired from the company that
day. Also, the company restated earnings going back to 1997. Enron had losses of $591 million
and had $628 million in debt by the end of 2000. The final blow was dealt when Dynegy
(NYSE: DYN

), a company that had previously announced would merge with the Enron, backed out of the
deal on Nov. 28. By Dec. 2, 2001, Enron had filed for bankruptcy.
Once Enron's Plan of Reorganization was approved by the U.S. Bankruptcy Court, the
new board of directors changed Enron's name to Enron Creditors Recovery Corp. (ECRC). The
company's new sole mission was "to reorganize and liquidate certain of the operations and
assets of the 'pre-bankruptcy' Enron for the benefit of creditors." The company paid its creditors
more than $21.7 billion from 2004-2011. Its last payout was in May 2011.

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

Several of Enron's execs were charged with a slew of charges, including conspiracy, insider
trading, and securities fraud. Enron's founder and former CEO Kenneth Lay was convicted of
six counts of fraud and conspiracy and four counts of bank fraud. Prior to sentencing, though,
he died of a heart attack in Colorado.

Enron's former star CFO Andrew Fastow plead guilty to two counts of wire fraud and securities
fraud for facilitating Enron's corrupt business practices. He ultimately cut a deal for cooperating
with federal authorities and served a four-year sentence, which ended in 2011.
Ultimately, though, former Enron CEO Jeffrey Skilling received the harshest sentence of anyone
involved in the Enron scandal. In 2006, Skilling was convicted of conspiracy, fraud, and insider
trading. Skilling originally received a 24-year sentence, but in 2013 it was reduced by 10 years.
As a part of the new deal, Skilling was required to give $42 million to the victims of the Enron
fraud and to cease challenging his conviction. Skilling remains in prison and is scheduled for
release on Feb. 21, 2028.

New Regulations As a Result of the Enron Scandal

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

The Enron scandal resulted in other new compliance measures. Additionally, the Financial
Accounting Standards Board (FASB) substantially raised its levels of ethical conduct. Moreover,
company's boards of directors became more independent, monitoring the audit companies and
quickly replacing bad managers. These new measures are important mechanisms to spot and
close the loopholes that companies have used as a way to avoid accountability.

The Bottom Line

At the time, Enron's collapse was the biggest corporate bankruptcy to ever hit the financial world
(since then, the failures of WorldCom, Lehman Brothers, and Washington Mutual have
surpassed it). The Enron scandal drew attention to accounting and corporate fraud, as its
shareholders lost $74 billion in the four years leading up to its bankruptcy, and its employees
lost billions in pension benefits. As one researcher states, the Sarbanes-Oxley Act is a "mirror
image of Enron: the company's perceived corporate governance failings are matched virtually
point for point in the principal provisions of the Act." (Deakin and Konzelmann, 2003).

Increased regulation and oversight have been enacted to help prevent corporate scandals of
Enron's magnitude. However, some companies are still reeling from the damage caused by
Enron. Most recently, in March 2017, a judge granted a Toronto-based investment firm the right
to sue former Enron CEO Jeffery Skilling, Credit Suisse Group AG, Deutsche Bank AG and
Bank of America's Merrill Lynch unit over losses incurred by purchasing Enron shares.
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II. Source: encyclopedia britanicca

As 2002 began, energy Trader Enron Corp. found itself at the centre of one of corporate
America’s biggest scandals. In less than a year, Enron had gone from being considered one of
the most innovative companies of the late 20th century to being deemed a byword for corruption
and mismanagement.
Enron was formed in July 1985 when Texas-based Houston Natural Gas merged with
InterNorth, a Nebraska-based natural gas company. In its first few years, the new company was
simply a natural gas provider, but by 1989 it had begun trading natural gas commodities, and in
1994 it began trading electricity.
The company introduced a number of revolutionary changes to energy trading, abetted by the
changing nature of the energy markets, which were being deregulated in the 1990s and thus
opening the door for new power traders and suppliers. Enron tailored electricity and natural gas
contracts to reflect the cost of delivery to a specific destination—creating in essence, for the first
time, a nationwide (and ultimately global) energy-trading network. In 1999 the company
launched EnronOnline, an Internet-based system, and by 2001 it was executing on-line trades
worth about $2.5 billion a day.
By century’s end Enron had become one of the most successful companies in the world, having
posted a 57% increase in sales between 1996 and 2000. At its peak the company controlled
more than 25% of the “over the counter” energy-trading market—that is, trades conducted party-
to-party rather than over an exchange, such as the New York Mercantile
Exchange. Enron shares hit a 52-week high of $84.87 per share in the last week of 2000.
Much of Enron’s balance sheet, however, did not make sense to analysts. By the late
1990s, Enron had begun shuffling much of its debt obligations into offshore partnerships—many
created by Chief Financial Officer Andrew Fastow. At the same time, the company was
reporting inaccurate trading revenues. Some of the schemes traders used included serving as a
middleman on a contract trade, linking up a buyer and a seller for a future contract, and then
booking the entire sale as Enronrevenue. Enron was also using its partnerships to sell contracts
back and forth to itself and booking revenue each time.
In February 2001 Jeffrey Skilling, the president and chief operating officer, took over as Enron’s
chief executive officer, while former CEO Kenneth 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.
As rumours about Enron’s troubles abounded, the firm shocked investors on October 16 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. At the same time,
some officials at Arthur Andersen LLP, Enron’s accountant, began shredding documents related
to Enron audits.
By October 22 the Securities and Exchange Commission had begun an inquiry into Enron and
the partnerships; a week later the inquiry had become a full investigation. Fastow was forced
out, while Lay began calling government officials, including Federal Reserve Chairman Alan
Greenspan, Treasury Secretary Paul O’Neill, and Commerce Secretary Donald Evans. In some
cases, officials said, Lay was simply informing them of Enron’s troubles, but Lay reportedly
asked for Evans to intervene with Moody’s Investors Service, which was considering
downgrading Enron bonds to noninvestment-grade status. Evans declined.
On November 8 Enron revised its financial statements for the previous five years,
acknowledging that instead of taking profits, it actually had posted $586 million in losses. Its
stock value began to crater—it fell below $1 per share by the end of November and was delisted
on Jan. 16, 2002.

On Nov. 9, 2001, rival energy trader Dynegy Inc. said it would purchase the company for $8
billion in stock. By the end of the month, however, Dynegy had backed out of the deal, citing
Enron’s downgrade to “junk bond” status and continuing financial irregularities—Enron had just
disclosed that it was trying to restructure a $690 million obligation, for which it was running the
risk of defaulting.
On December 2 Enron, which a year before had been touted as the seventh largest company in
the U.S., filed for Chapter 11 bankruptcy protection and sued Dynegy for wrongful termination of
the failed acquisition. A month later Lay resigned, and the White House announced that the
Department of Justice had begun a criminal investigation of Enron.
By mid-2002 the once-mighty company was in tatters. Enron’s energy-trading business had
been sold off to the European bank UBS Warburg in January. Throughout the spring top Enron
officials were subpoenaed to testify before congressional hearings. The majority of Enron’s
employees were unemployed, and their stock plans had become almost worthless. In June
Arthur Anderson was convicted in federal court of obstruction of justice, while many other
American companies scrambled to reexamine or explain their own accounting practices. As
investigations continued into Enron’s financial dealings, government connections, and possible
involvement in California’s energy problems, it appeared likely that the political and economic
fallout would be making headlines for some time.
 III. SOURCE: the economist

Enron
The real scandal
America's capital markets are not the paragons they were cracked up to be

THE collapse of Enron was spread over several months late last year, when the world's
attention was still on Afghanistan. The Texas-based energy-trading giant, once America's
seventh-biggest company, declared bankruptcy on December 2nd. Yet it has taken until now for
this simmering affair to boil over in Washington, DC. And, as so often, the ensuing scandal risks
focusing on the wrong issues.
On Capitol Hill, much of the talk has been of the close links that Kenneth Lay, Enron's chairman,
had with George Bush and other Texas Republicans. The press has been burrowing into how
often Mr Lay and other Enron bosses called administration officials to beg fruitlessly for help.
There has been tut-tutting about congressmen collecting campaign money from Enron, which,
far from buying Republicans alone, was admirably bipartisan: three-quarters of the Senate took
Enron cash. And public indignation has been roused over how much Mr Lay and his colleagues
made from Enron shares, unlike their workers, whose pension funds were largely invested in
Enron stock that they were unable to sell in time.

Yet little of this is new. Certainly, Enron's demise confirms some unattractive features of
American public life (see article). The campaign-finance system puts too many politicians under
obligations to big-business donors: Enron lobbied successfully for exemption from financial
regulation for its energy-trading arm, and it also helped to draw up the administration's energy
policy. Executive pay and stock options have long given bosses too much for doing too little.
Some companies have been at fault in encouraging workers to invest pension money in their
shares; after Enron, legislation to limit this is urgently needed. But for the most part, the
bankruptcy of Enron was just part of the rough-and-tumble of American capitalism, the most
successful system the world has known.
In this section
 The real scandal
 Stoiber v Schröder
 The saving of Pakistan?
 Still giving Italy a bad name
 The rights of terrorists
 Restoring the fiscal option
Reprints
Related items
 Enron: The twister hitsJan 17th 2002
 The politics of Enron: Four committees in search of a scandalJan 17th 2002

Who guards the guardians?

Yet there is one big issue that should now attract more attention: the governance of the public
capital markets, and especially the role played by auditors. The capital markets, and indeed
capitalism itself, can function efficiently only if the highest standards of accounting, disclosure
and transparency are observed. In America, well-policed stockmarkets, fearsome regulators at
the Securities and Exchange Commission (SEC), stern accounting standards in the form of
generally accepted accounting principles (GAAP), and the perceived audit skills of the big five
accounting firms, have long been seen as crucial to the biggest, most liquid and most admired
capital markets in the world.
The collapse of Enron is now raising some big questions (see article). Andersen, the company's
auditor, has admitted to an “error of judgment” in its treatment of the debt of one of Enron's off-
balance-sheet vehicles; these vehicles led to an overstatement of profits by almost $600m over
the years 1997-2000. This week Andersen fired the partner in charge of the Enron audit, when it
found that he had ordered the disposal of documents even after the SEC had subpoenaed the
firm as part of its investigation into Enron. This is not the first time that Andersen has been in
trouble: last year, it was fined over its audit of another Texan company, Waste Management,
and it also had to settle a suit over the audit of Sunbeam, a Florida-based company.
If this were simply a case of one accounting firm doing wrong, that would be regrettable but
containable. Andersen may go under thanks to Enron litigation anyway. But the truth is that it is
not unique. It may have been unusually culpable, but all the accounting firms have made
mistakes in the past. Only this week, KPMG became the latest to be censured, this time for
breaking rules barring investment in audit clients.
That points to the need for systemic reforms, in three areas. The first is the regulation of
auditors. For years the profession has insisted that self-regulation and peer review are the right
way to maintain standards. Yet Enron has shown that this is no longer enough. The Public
Oversight Board should be turned from a self-regulatory body appointed and financed by
accountants into a statutorily independent organisation reporting to the SEC. And it should be
given teeth, including the power to ban or fine auditors for misdeeds.
Second is the urgent need to eliminate conflicts of interest in accounting firms. Andersen
collected audit fees of $25m from Enron, its second-biggest client, last year, but it earned even
more for consulting and other work. The accounting firms have fought off attempts to limit or
stop them undertaking consulting work for audit clients; they insist that there is no real conflict of
interest. Yet if confidence in auditing is to be regained, perception is as important as reality.
The SEC should now pursue again the ban that its previous chairman, Arthur Levitt, sought to
impose in 1999. There is also a strong case for compulsory rotation of auditors, say every seven
years: Andersen had audited Enron since its birth in 1983.
Lastly come America's accounting standards. GAAP standards used to be thought the most
rigorous in the world. Yet under British standards, Enron would not have been able to overstate
its profits by so much. And, once again, although Enron may have been egregious, it is not a
lone offender. Several dotcoms and technology companies have used what is euphemistically
called “aggressive accounting” to boost reported earnings. Too many companies have got away
with “pro forma” accounting that delivers nice numbers by omitting such items as stock write-
offs, special transactions, interest charges or depreciation. And the accounting treatment of
stock options has long been a disgrace.
The SEC and its standard-setting body, the Financial Accounting Standards Board, should now
revisit GAAP; they might even embrace international accounting standards instead. There is a
lesson from British experience in the 1980s, when several audit scandals led to both tougher
regulation and more rigorous accounting standards. The Enron scandal shows that America can
no longer take the pre-eminence of its accounting for granted. That is a far bigger concern than
any number of congressional investigations
IV. source: the balance.com

The Enron Scandal That Prompted the

Sarbanes-Oxley Act
Sarbanes-Oxley, or SOX, is a federal law that is a comprehensive reform of business
practices. The 2002 Sarbanes-Oxley Act aims particularly at public accounting firms that
participate in audits of corporations and was passed in response to a number of corporate
accounting scandals that occurred between 2000-2002. This act set new standards
for public accounting firms, corporate management, and corporate boards of directors.

What Prompted the Sarbanes-Oxley Act?

The Enron scandal was certainly enough to show the American public and its
representatives in Congress that new compliance standards for public accounting and
auditing were needed. Enron was one of the biggest and, it was thought, one of the most
financially sound companies in the U.S.

Enron, located in Houston, TX, was considered one of a new breed of American
companies that participated in a variety of ventures related to energy. It bought and sold
gas and oil futures. It built oil refineries and power plants. It became one of the world's
largest pulp and paper, gas, electricity, and communications companies before it
bankrupted in 2001. Several years before the Enron bankruptcy, the government
had deregulated the oil and gas industry to allow more competition, but this also made it
easier to cheat. Enron, among other companies, took advantage of this deregulation.

The various misdeeds and crimes committed by Enron were extensive and ongoing.
Particularly damaging misrepresentations pumped up earnings reports to shareholders,
many of whom eventually suffered devastating losses when the company failed. But there
were many other instances of dishonesty and fraud, including actual embezzlement of
corporate funds by Enron executives and illegal manipulations of the energy market.

What Is the Sarbanes-Oxley Act?

In order to cut down on the incidence of corporate fraud, Senator Paul Sarbanes and
Representative Michael Oxley drafted the Sarbanes-Oxley Act. The intent of the SOX
Act was to protect investors by improving the accuracy and reliability of corporate
disclosures by
  closing loopholes in recent accounting practices
 strengthening corporate governance rules
 increasing accountability and disclosure requirements of corporations, especially
corporate executives, and corporation's public accountants
 increasing requirements for corporate transparency in reporting to shareholders
and descriptions of financial transactions
 strengthening whistle-blower protections and compliance monitoring
 increasing penalties for corporate and executive malfeasance
 authorizes the creation of the Public Company Accounting Oversight board to
further monitor corporate behavior, especially in the area of accounting

In response to what was widely seen as collusion by Enron's accountants, The Arthur
Andersen firm, in Enron's fraudulent behavior, SOX also changes the way corporate
boards deal with their financial auditors. All companies, according to SOX, must provide
a year-end, report about the internal controls they have in place and the effectiveness of
those internal controls.

Although the Sarbanes-Oxley Act of 2002 is generally credited with having reduced
corporate fraud and increasing investor protections, it also has its critics, some of whom
note the degree to which Congress has weakened the act by withholding funding
necessary to put these reforms into motion and by passing bills that effectively counter
the intent of the act. Other critics, on the contrary, oppose the act because it increases
corporate costs and reduces corporate competitiveness.