ENRON SCANDAL

By – Nimit Goel
Harsh Solanki
Manav
Sharma
Anurag
Kumar
Introduction

Enron scandal, series of events that resulted in

the bankruptcy of the U.S. energy,
commodities, and services company Enron
Corporation and the dissolution of Arthur
Andersen LLP, which had been one of the
largest auditing and accounting companies in
the world. The collapse of Enron, which held
more than $60 billion in assets, involved one of
the biggest bankruptcy filings in the history of
the United States, and it generated much
debate as well as legislation designed to
improve accounting standards and practices,
with long-lasting repercussions in the financial
world.
 Founding of Enron and its rise
Enron was founded in 1985 by Kenneth Lay in the merger of two natural-gas-
transmission companies, Houston Natural Gas Corporation and InterNorth, Inc.;
the merged company, HNG InterNorth, was renamed Enron in 1986. After the
U.S. Congress adopted a series of laws to deregulate the sale of natural gas in the
early 1990s, the company lost its exclusive right to operate its pipelines. With the
help of Jeffrey Skilling, who was initially a consultant and later became the
company’s chief operating officer, Enron transformed itself into a trader of
energy derivative contracts, acting as an intermediary between natural-gas
producers and their customers. The trades allowed the producers to mitigate the
risk of energy-price fluctuations by fixing the selling price of their products
through a contract negotiated by Enron for a fee. Under Skilling’s leadership,
Enron soon dominated the market for natural-gas contracts, and the company
started to generate huge profits on its trades.
Skilling also gradually changed the culture of the company to emphasize aggressive
trading. He hired top candidates from MBA programs around the country and created
an intensely competitive environment within the company, in which the focus was
increasingly on closing as many cash-generating trades as possible in the shortest
amount of time. One of his brightest recruits was Andrew Fastow, who quickly rose
through the ranks to become Enron’s chief financial officer. Fastow oversaw the
financing of the company through investments in increasingly complex instruments,
while Skilling oversaw the building of its vast trading operation.

The bull market of the 1990s helped to fuel Enron’s ambitions and contributed to its
rapid growth. There were deals to be made everywhere, and the company was ready
to create a market for anything that anyone was willing to trade. It thus traded
derivative contracts for a wide variety of commodities—including electricity, coal,
paper, and steel—and even for the weather. An online trading division, Enron Online,
was launched during the dot-com boom, and by 2001 it was executing online trades
worth about $2.5 billion a day. Enron also invested in building a broadband
telecommunications network to facilitate high-speed trading.
Downfall and bankruptcy
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.
 Lawsuits and Legislation
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.
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.
 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
Enron’s mountains of debt and toxic assets from investors and creditors.2 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 counterparty 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 was the second
significant difference: Enron’s failure to disclose conflicts of interest. While Enron
disclosed the SPVs’ existence to the investing public—although it’s quite likely that
few people understood them—it failed to adequately disclose the non-arm’s-length
deals between the company and the SPVs.12
 Arthur Andersen and Enron
In addition to 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.15

By April 2001, many analysts started to question Enron’s

earnings and transparency.
 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.19 The conviction was
overturned later on appeal; however, the firm was deeply disgraced by the scandal and dwindled into a holding
company.20

A group of former partners bought the name in 2014, creating a firm named Andersen Global.21

Several of Enron’s executives were charged with conspiracy, insider trading, and securities fraud. Lay, Enron’s founder and
former CEO, was 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.22

Fastow, Enron’s former star CFO, pleaded 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 2011.23

Skilling, Enron’s former CEO, ultimately received the harshest sentence of anyone involved in the scandal. In 2006, Skilling
was convicted of conspiracy, fraud, and insider trading. Skilling originally received a 17½-year sentence, but in 2013, it
was reduced by 14 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.24 Skilling was originally scheduled for release on Feb. 21, 2028, but was
instead released early on Feb. 22, 2019.25
New Regulations After Scandal
Enron’s collapse and the financial havoc that 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,
then-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.

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.
 The Wall Street Darling Crumbles
By the fall of 2000, Enron was starting to crumble under its own weight. Skilling hid the financial losses of the
trading business and other operations of the company using MTM accounting.10 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 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 MTM practice led to schemes 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 (CFO) 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.
ENRON SCANDAL TIMELINE