Financial Management Arsalan Haneef Malik

Agency Issue – A case study

Enron (2001)
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.
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
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

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Financial Management Arsalan Haneef Malik
Agency Issue – A case study
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.
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.

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Financial Management Arsalan Haneef Malik
Agency Issue – A case study
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.
WorldCom (2002)
Not long after the collapse of Enron, the equities market was rocked by another billion-dollar
accounting scandal. Telecommunications giant WorldCom came under intense scrutiny after
yet another instance of some serious "book cooking." WorldCom recorded operating
expenses as investments. Apparently, the company felt that office pens, pencils, and paper
were an investment in the future of the company and, therefore, expensed (or capitalized)
the cost of these items over a number of years.
In total, $3.8 billion worth of normal operating expenses, which should all be recorded as
expenses for the fiscal year in which they were incurred, were treated as investments and
were recorded over a number of years. This little accounting trick grossly exaggerated profits
for the year the expenses were incurred. In 2001, WorldCom reported profits of more than
$1.3 billion. In fact, its business was becoming increasingly unprofitable. Who suffered the
most in this deal? The employees: tens of thousands of them lost their jobs.
The next ones to feel the betrayal were the investors who had to watch the gut-wrenching
downfall of WorldCom's stock price, as it plummeted from more than $60 to less than $1.

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