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.
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.”
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.