Home History of Financial Crises The Enron Scandal (2001)

History of Financial Crises

THE ENRON SCANDAL (2001)

September 29, 2021

Both of these buildings in downtown Houston, 1400 Smith Street and 1500 Louisiana Street, were
formerly occupied by Enron.

August 2021 marked the 20th anniversary of arguably the most notorious corporate-accounting scandal
of all time. It may not have been the biggest in dollar terms, or even the most severe in terms of
criminality and personnel held culpable, but the Enron Corp. scandal of 2001 remains perhaps the most
impactful of all time. One of the largest companies in the United States collapsed virtually overnight,
with the fallout of its malfeasance being billions of dollars stolen, thousands of jobs wiped out, dozens
of criminal convictions and even one incident of suicide.

Indeed, when Enron filed for bankruptcy protection on December 2, 2001, it was the largest company to
do so in US history until that point in time. It was also once the world’s largest energy-trading company,
with a market value of up to $68 billion, before its collapse destroyed thousands of jobs and more than
$2 billion in pension plans. The shockwaves the scandal sent across capital markets were seismic,
shaking investor confidence to its core and changing the corporate and regulatory landscapes forever.

Jeffrey Keith Skilling was CEO of Enron Corporation at the time of the Enron scandal.

Enron was born in 1985 as a result of the merger between Houston Natural Gas Company and
InterNorth Inc., with the chief executive officer (CEO) of Houston, Kenneth Lay, taking the reins of the
newly formed entity. By 1990, Lay had hired Jeffrey K. (Jeff) Skilling, a partner at consulting firm
McKinsey, which at the time was advising Enron. Two years later, Skilling had created a new accounting
technique called mark-to-market (MTM) accounting, which was granted formal approval by the U.S.
Securities and Exchange Commission (SEC) in 1992.
MTM accounting enables a company to adjust the value of its balance-sheet assets from their historical
value to the current fair market value (FMV), and thus means that income can be calculated as an
estimate of the present value of net future cash flow. Should a contract be worth $100 million over the
coming 10 years, for instance, MTM accounting would enable a company to write $100 million in its
books on the day the contract was signed, irrespective of whether the deal ultimately matched
expectations. As such, Enron was able to inflate its present-day worth through its financial statements,
substantially over and above what it had actually earned, and thus obfuscate the truth about its
business performance.

This was perhaps no more clearly illustrated than when Enron Broadband Services, a subsidiary of
Enron, partnered with Blockbuster in July 2000 in a 20-year deal to sell movie-on-demand services
through its broadband network. In the pre-Netflix era, the prospect of delivering movies to people’s
computers or televisions via broadband was a new and exciting one. And using MTM accounting meant
that Enron could book all 20 years of forward projections from the deal—in this case, $110 million of
estimated profit—to its financial statements for the mid-year 2000.

But the partnership ended up being terminated after movie studios expressed their opposition to
Blockbuster providing such services. The failed deal and Blockbuster’s withdrawal, however, did not stop
Enron from continuing to claim future profits and thus sell shares of the company at hugely inflated
prices, despite the deal resulting in a loss. Arguably, this was the first major incident to kick off the
external scrutiny into Enron’s dealings and its questionable MTM practices.

Eventually, the unit CEO, Joseph Hirko, and vice presidents F. Scott Yeager and Rex Shelby were charged
with conspiracy, fraud, insider trading and money laundering related to those practices. And Kevin
Howard, the former chief financial officer (CFO), and Michael W. Krautz, a former senior director of
accounting, of Enron Broadband Services were charged with conspiracy and fraud tied to the fabrication
of earnings stemming from the failed Blockbuster deal.

The company also used accounting tricks to misclassify loan transactions as revenues just before
quarterly financial-reporting dates. For instance, they entered into a deal with Merrill Lynch in which the
US bank bought Nigerian barges with a buyback guarantee from Enron just before its earnings deadline.
Enron misreported this bridge loan as a true sale before buying the barges back a few months later.
Merrill Lynch was eventually held culpable in November for its role in assisting Enron in its accounting
fraud, with some of the bank’s executives spending almost a year in prison.
Special purpose entities (SPEs) played a significant role in Enron’s misdeeds. Dubbed as the “Raptors”,
these SPEs were created by the company—specifically by CFO Andrew Fastow with the apparent
blessing of Skilling, Lay and the board of directors—to protect itself against MTM losses from its equity
investments. Once these stocks began performing poorly, Enron “sold” them into the Raptors—LJM
Cayman. L.P. (LJM1) and LJM2 Co-Investment L.P. (LJM2)—to shore up the appearance of its financial
statements. In other words, LJM1 and LJM2 were created purely for the purpose of acting as the
external equity investor required for the SPEs being used by Enron.

Fastow stated much of this when he testified before the U.S. Congress in the aftermath of the scandal
and also confirmed that he himself stood to “benefit greatly from the partnerships”; indeed, he ended
up pocketing some $45 million in the profit from his activity. In January 2004, he pleaded guilty to two
counts of fraud, agreed to a prison term of up to 10 years and forfeited $24 million. “I was being a hero
for Enron,” he said repeatedly during the testimony. “We were using this to inflate our earnings.”

According to the US government, Enron’s board also approved moving an affiliated company,
Whitewing, off the books while guaranteeing its debt with $1.4 billion in Enron’s stock and helping it
obtain funding to purchase Enron’s assets. “From the Raptor transactions, and numerous others
described in the Powers Report, Congressional testimony, and newspaper reports, Enron may have paid
out well over $300 million—in the form of cash, investments, and Enron stock—to advisors and SPE
equity holders in order to sustain its network of off–balance sheet financing entities,” noted The CPA
Journal in 2003. “By comparison, the Financial Accounting Foundation spent just $22 million to generate
and maintain its FASB [Financial Accounting Standards Board] and GASB [Government Accounting
Standards Board] standards-setting programs. As a result, it is not difficult to see how determined
companies can run rings around GAAP [generally accepted accounting principles], exploiting
technicalities and loopholes to create financial statements that even the most sophisticated investors
cannot understand.”

In terms of Enron’s path towards bankruptcy, the failed Blockbuster deal kicked off a gradually
expanding wave of scrutiny into the company’s accounts from the financial press. The Texas Journal ran
a story in September 2000 about the shortfalls and lack of transparency surrounding the MTM
accounting techniques being increasingly adopted by the energy industry. The following March, the
Fortune article “Is Enron Overpriced?” questioned the company’s stock valuation and posited that
investors were unaware of how exactly Enron made money, while concerns voiced by the article’s
author, Bethany McLean, were dismissed by Skilling when she tried to discuss her findings with him
before publishing the article. And perhaps most infamously, on a conference call with Wall Street
analyst Richard Grubman who pressed him into explaining more about Enron’s accounting practices,
Skilling retorted, “Well uh…. Thank you very much, we appreciate it…. Asshole.” The response was met
with considerable astonishment from the public.
By late October, following mounting complaints from analysts over the opacity of Enron’s financial
statements, ratings agency Moody’s had lowered Enron’s credit rating to just two levels above junk
status. A few days later, it was revealed to the public that the SEC had begun a formal investigation into
Enron and its dealings with “related parties”.

By late November 2001, Enron’s stock price had plunged to less than $1 per share, in stark contrast to its
mid-2000 peak of $90.75. The company was estimated to have $23 billion in liabilities from both
outstanding debts and guaranteed loans, raising speculation that it would have to declare bankruptcy.
Enron Europe, the holding company for Enron’s operations in Continental Europe, was the first to do so
on November 30, a day before the board voted unanimously to file for Chapter 11 protection for the
rest of the company.

At $63.4 billion in total assets, Enron’s was the largest corporate bankruptcy in US history until the
WorldCom scandal just one year later. Around 4,000 jobs were lost, and almost two-thirds of the 15,000
employees’ savings plans that depended on Enron stock, which had been purchased at $83 at the start
of the year, became worthless.

Additional fallout from the scandal was most directly suffered by Enron’s accounting firm, Arthur
Andersen, which earned $52 million in audit and consulting fees in 2000, more than one-quarter of total
audit fees generated by the company’s Houston office clients. Andersen was accused of failing to apply
sufficient standards during its audits of Enron’s books and conducting itself in a way to simply receive its
fees without sufficiently examining Enron’s accounting practices.

“When confronted by evidence of Enron’s high-risk accounting, all of the Board members interviewed by
the Subcommittee pointed out that Enron’s auditor, Andersen, had given the company a clean audit
opinion each year,” the US Senate found. “None recalled any occasion on which Andersen had
expressed any objection to a particular transaction or accounting practice at Enron, despite evidence
indicating that, internally at Andersen, concerns about Enron’s accounting were commonplace. But a
failure by Andersen to object does not preclude a finding that the Enron Board, with Andersen’s
concurrence, knowingly allowed Enron to use high risk accounting and failed in its fiduciary duty to
ensure the company engaged in responsible financial reporting.”
Sherron Watkins (left), Vice President of Corporate Development for the Enron Corporation, Skilling
attorney Bruce Hiler (middle), and Jeffrey Skilling (right), former CEO of Enron, during the Senate
Commerce hearing on the company’s bankruptcy | Photo Credit: Ferrell, Scott J – Library of Congress

It was eventually revealed that several conflicts of interest arose between Andersen and Enron. For
example, Andersen’s Houston office, which conducted the audits, had the power to overrule any
criticism levelled at Enron’s accounting practices by Andersen’s Chicago partner. It was also discovered
that Enron’s management had applied considerable pressure on Andersen’s auditors to meet its
earnings expectations. For instance, it would briefly hire other accounting companies to conduct some
accounting tasks and thus give the impression that it would replace Andersen. The shredding of almost
30,000 e-mails and other files after Enron’s malpractice was made public also raised suspicion of
widespread collusion between the two parties.

Ultimately, Andersen’s involvement with Enron caused the accounting firm to break up, again leading to
thousands of job losses. “The evidence available to us suggests that Andersen did not fulfill its
professional responsibilities in connection with its audits of Enron’s financial statements, or its
obligation to bring to the attention of Enron’s Board (or the Audit and Compliance Committee) concerns
about Enron’s internal contracts over the related-party transactions,” according to the (William C.)
Powers Committee, which was appointed by Enron’s board to review its accounting practices in October
2001.

The 2002 enactment of the Sarbanes-Oxley Act did strengthen the oversight of accountants; reduced
the potential for conflicts of interests faced by auditors, specifically by barring them from providing
various consulting services to audit clients; and enhanced the SEC’s enforcement tools.

But it wasn’t until February 2004 that the SEC finally indicted Skilling, charging him with “violating, and
aiding and abetting violations of, the antifraud, lying to auditors, periodic reporting, books and records,
and internal controls provisions of the federal securities laws”.

“In this scandal, as in others, we are by now all too familiar with executives who bask in the attention
that follows the appearance of corporate success, but who then shout their ignorance when the
appearance gives way to the reality of corruption,” Stephen M. Cutler, director of the SEC’s Enforcement
Division, said at the time. “Let there be no mistake that today’s enforcement action against Mr. Skilling
places accountability exactly where it belongs.”
A federal jury in 2006 convicted him on 19 out of 28 criminal counts, including fraud, conspiracy and
insider trading. He was sentenced to 24 years in prison and ordered to forfeit $45 million. Lay was
convicted of all six counts of securities and wire fraud for which he had been tried, but he died in July
2006 before serving his sentence of potentially up to 45 years behind bars.