Enron Bankruptcy Reveals Massive Financial Fraud

Date December 2, 2001

When the Texas energy corporation Enron suddenly went bankrupt, it took with it the life savings and pensions of many of its employees and revealed systematic financial corruption and mismanagement that went beyond the company’s walls to a respectable accounting firm and the halls of government.

Locales New York, New York; Houston, Texas

Key Figures

• Kenneth Lay (1942-2006), Enron’s chief executive officer and chairman of the board
• Jeffrey Skilling (b. 1953), Enron’s president and chief operating officer
• Sherron Watkins (b. 1959), Enron’s vice president of corporate development, who urged Lay to investigate Enron’s accounting practices

Summary of Event

Enron Corporation began its corporate existence in 1985, when Houston Natural Gas merged with InterNorth, another natural gas company that was based in Omaha, Nebraska. The combined companies controlled a system of natural gas pipelines that stretched the length and breadth of the United States, which in theory should have given it a significant competitive advantage. However, the deregulation of natural gas transmission, part of U.S. president Ronald Reagan’s policies of reducing government regulation of corporations, significantly blunted that advantage by eliminating Enron’s ability to claim an exclusive right to use its pipelines.

As a result, the new company’s chief executive officer (CEO), Kenneth Lay, decided to move out of the traditional areas in which the precursor companies had operated, particularly gas pipelines and power-generating plants, to such areas as telecommunications, pulp and paper, and computers. To chart Enron’s new course, Lay retained the consulting firm of McKinsey & Company, which sent consultant Jeffrey Skilling to Houston. Skilling advised Enron executives to leverage the company’s vast size to effectively create its own market through buying contracts that locked in both costs and prices, assuring a steady flow of business. Doing this involved creating a number of special purpose entities, or SPEs, that would carry out the transactions, often in joint ventures with other companies. By 1999, Enron even created its own stock-trading company, EnronOnline, which was used by almost all energy companies.

At first the plan worked well enough, and Enron’s growth was so spectacular that Skilling was offered a senior executive position, that of chief operating officer, with Enron. However, this growth was almost entirely dependent upon the presence of a strong bull market in the larger economy as well as the rapid growth of the high-tech sector that later came to be known as the dot-com bubble because it lacked fundamentals. Because so much of Enron’s growth, and the resulting rapid growth of the value of its stock, had no fundamentals, the use of SPEs became increasingly a sort of shell game, moving money from one part of the company to another to create the illusion of vibrant growth and hide unprofitable ventures. Arthur Andersen, one of the most prestigious accounting firms in the United States, was involved in this systematic deception as well, which was further enabled by lax regulatory oversight.

As the U.S. economy began to slow at the beginning of the twenty-first century, the continued rapid growth of Enron became unsustainable. More desperate financial measures had to be taken to maintain the illusion that enabled Enron’s stock to continue climbing. Skilling began to crack under the strain. In one well-publicized event, he used a vulgarism in a sarcastic expression of gratitude to Wall Street analyst Richard Grubman. Although within the corporate culture of Enron the expression was frequently repeated in a way that clearly regarded the wrong to be that of Grubman rather than Skilling, it was a warning sign of upheavals to come.

During the middle of 2001, Skilling’s mental situation had become sufficiently fragile that he resigned, giving the position of CEO back to Lay on August 14. The next day, Sherron Watkins, Enron’s vice president of corporate development, wrote an e-mail to Lay that many consider to be the start of Enron’s downfall. In her memo, Watkins expressed reservations about how Skilling’s abrupt departure would play in the securities market and identified several key weaknesses in Enron’s corporate structure, particularly the Raptor and Condor deals. Raptor and Condor were SPEs that had functioned to hedge risk in particularly tricky areas of the economy. In effect, Watkins was urging Lay to investigate Enron’s accounting practices.

Lay then called a meeting with Enron’s general counsel, but the wake-up call came too late. Although Enron hired the legal firm Vinson & Elkins to conduct an internal investigation, the damage was already too extensive to be corrected. One day before Enron was scheduled to announce its third-quarter results, Vinson & Elkins returned its report, claiming that while the Raptor and Condor deals were creative, they did not represent a formal conflict of interest.

Even this positive report could not cushion the blow of October 16, when Enron revealed that it had sustained more than $100 million in losses, particularly in its new power company deal and its investment in broadband telecommunications. The news sent Enron’s stock prices tumbling, and on October 22 the U.S. Securities and Exchange Commission (SEC) requested information on several key transactions. Further bad news followed when Enron announced it would have to redo a number of key filings as a result of the consolidation of several previously separate entities through which it had accomplished some of its more risky deals.

These filings revealed that many of the SPEs through which Enron had done business were in fact not independent under SEC regulations, but had been treated as though they qualified to avoid consolidating them and their financial losses into Enron’s financial statements. The resulting loss of confidence led to further collapse in the value of Enron’s stock, until major credit-rating agencies that had previously ranked Enron as a blue-chip-stock company reevaluated it as a junk stock and nearly worthless.

In a desperate attempt to salvage a disintegrating situation, the smaller energy company Dynegy, Inc., attempted a takeover of the collapsing company. However, this deal fell through when Enron revealed that its declining credit rating would result in an additional $690 million of obligations. As a result, Enron filed for Chapter 11 bankruptcy protection in a New York bankruptcy court on December 2. Enron’s subsequent corporate activities were directed to the company’s dissolution and the satisfaction of its creditors.

Impact

Because the complicated financial wheeling and dealing that caused Enron’s paper wealth to implode was difficult for people without an extensive background in high finance to understand, most of the public outcry was focused upon the scandal’s effect on ordinary people: Millions of American investors, including longtime Enron employees, suddenly lost billions of dollars in savings, investments, and retirement plans. People who had thought their retirements were secure were now looking at the very real possibility of having to work until they could work no more. As a result of this betrayal of trust, employees and investors demanded accountability from the executives who had been involved in the questionable accounting practices.

Both Lay and Skilling were found criminally liable and given long prison sentences, although Lay died of a heart attack shortly before he was supposed to report for incarceration. There were even some questions about whether Lay deliberately indulged in pleasures that were apt to increase his risk of a heart attack, either in an effort to grab a few last bits of pleasure before a sentence that might well be for life or in a cynical effort to cheat prison. The accounting firm Arthur Andersen also was implicated in the financial scandal, and it ultimately went out of business.

In addition, the scandal raised serious questions about the value of the limited-liability corporation, or LLC, and whether it enabled executives to evade the consequences of their decisions. Calls were made to make it easier to pierce the shield of incorporation and hold executives as individuals financially liable for bad decisions that materially harmed investors and involved a breach of trust. However, many analysts argued that reducing the liability protection afforded by corporate entities could actually do more harm than good by exposing ordinary investors to greater risk and by making executives more wary of taking aggressive action in pursuing business opportunities.

Bibliography

Coenen, Tracy. Essentials of Corporate Fraud. Hoboken, N.J.: John Wiley & Sons, 2008. An introductory guide to the white-collar crime of corporate fraud, written by a forensic, or investigative, accountant.

Fox, Loren. Enron: The Rise and Fall. Hoboken, N.J.: John Wiley & Sons, 2003. A corporate history of Enron, exploring how the scandal developed and spiraled out of control toward bankruptcy and the company’s collapse.

Fusaro, Peter C., and Ross M. Miller. What Went Wrong at Enron: Everyone’s Guide to the Largest Bankruptcy in U.S. History. Hoboken, N.J.: John Wiley & Sons, 2002. A detailed account of the corporate greed that led to Enron’s collapse.

Jenkins, Gregory J. The Enron Collapse. Upper Saddle River, N.J.: Pearson Education, 2003. An executive summary of the mechanisms that led to Enron’s bankruptcy and collapse. Discusses lessons learned in the scandal.

Smith, Rebecca, and John R. Meshwiller. Twenty-four Days: How Two “Wall Street Journal” Reporters Uncovered the Lies that Destroyed Faith in Corporate America. New York: HarperBusiness, 2003. Focuses upon the investigative reporting that revealed the fatal weaknesses in the management of Enron as a corporation.

Stewart, Bennet. “The Real Reasons Enron Failed.” Journal of Applied Corporate Finance 18, no. 2 (2006): 116-119. Argues that Enron failed as a company not because of criminal intent alone but also organizational design: that is, “bonus plans that paid managers to increase reported earnings”; “the use of market-to-market accounting”; and turning the finance department into a “profit center.”

Swartz, Mimi, with Sherron Watkins. Power Failure: The Inside Story of the Collapse of Enron. New York: Doubleday, 2003. Offers a firsthand account from the whistle-blower, Sherron Watkins, who courageously stepped forward to unmask Enron’s illegal manipulations.