Enron Scandal

I

Introduction

Enron Scandal, business scandal that came to symbolize the excesses of corporations during the long economic boom of the 1990s in the United States. Billed by Fortune magazine as “America’s Most Innovative Company” for six straight years from 1996 to 2001, the Enron Corporation became one of the largest bankruptcies in U.S. history in December 2001.

The company’s spectacular collapse resulted from the disclosure that it had reported false profits, using accounting methods that failed to follow generally accepted procedures. Both internal and external controls failed to detect the financial losses disguised as profits for a number of years. Enron’s managers, whose activities brought the company to the brink of ruin, escaped with millions of dollars as they retired or sold their company stock before its price plummeted. Enron employees were not so lucky. Many lost their jobs and a hefty portion of retirement savings invested in Enron stock.

The Enron scandal played a major role in shaking investor confidence in American business because the firm was able to hide its losses for nearly five years. Outside agencies, such as accounting firms, credit-rating businesses, and stock market analysts failed to warn the public about Enron’s business losses until they were obvious to all. Internal controls did not work, either. Enron’s board of directors, and especially its audit committee, apparently did not understand the complicated financial activities undertaken and consequently did not provide adequate oversight.

The scandal resulted in new legislation that reformed accounting practices and strengthened the ability of the Securities and Exchange Commission (SEC) to investigate accounting fraud. The Public Company Accounting Reform and Investor Protection Act of 2002 provided for the strictest government oversight of business financial reporting since the New Deal legislation of the 1930s. See also Accounting and Bookkeeping.

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In addition to the failure of outside auditors and internal corporate oversight, many experts believed that the federal government also bore some responsibility for the situation. Politicians in both the legislative and executive branches received millions of dollars in campaign donations from Enron during the period when the federal government decided to deregulate the energy industry, removing virtually all government controls. Deregulation was the critical act that made Enron’s rise as a $100-billion company possible.

II

Enron’s Origins

Enron began business in 1986 as a result of the merger of two natural gas companies intent on creating the first nationwide natural gas pipeline. At that time, energy production was a government-sanctioned monopoly. The government regulated the construction of power plants, the rates to be charged for power, and the maximum profits energy companies could earn. That all changed after the federal government deregulated the natural gas industry in the late 1980s and the electricity industry in the 1990s.

Under the leadership of its president, Kenneth Lay, Enron decided to take advantage of the newly deregulated markets for energy. In addition to delivering natural gas, Enron became a market middleman for energy, bringing together buyers and sellers of energy. Enron dominated the trading of energy contracts and financial instruments known as derivatives.

III

Nature of Derivatives

A derivative is an instrument whose value is “derived” from the underlying value of something else, such as a stock, a bond, or in the case of Enron’s derivatives, a unit of electricity. Derivatives are useful because they enable an investor to hedge against a decline in value. For example, Enron could enter a contract with a purchaser of electricity, such as a utility, guaranteeing that the purchaser would pay a certain price for a certain amount of electricity at a certain date in the future. Enron could then hedge its bet by signing a derivatives contract with a supplier of electricity who would guarantee that it would sell electricity at the purchaser’s price on the agreed-upon date.

By the late 1990s Enron controlled some 25 percent of all electricity and natural gas contracts traded worldwide, and the company was considered the best in the business. This success led Enron to act as a market middleman for other commodities as diverse as lumber and Internet bandwidth (the rate at which data can be delivered over the Internet). In 1999 Enron formed Enron Online, which quickly became the largest e-business site in the world.

The company also continued to invest in physical facilities. Enron bought into utilities in Brazil, India, and the United Kingdom. All of this required billions of dollars, which were raised from investors or borrowed from lenders. By 2000 Enron had 21,000 employees and $100 billion in revenue.

IV

Enron’s Decline

The year 2001 brought sobering news. In March a planned deal with Blockbuster Inc., a motion-picture video rental company, to provide movies over the Internet was canceled. In April, Enron revealed that it was owed more than $500 million by bankrupt California energy companies. In August its chief executive officer (CEO), Jeffrey Skilling, resigned, a sign that all was not well in the company. On October 16 Enron reported a third-quarter loss of $618 million. The next day Enron revealed that due to an accounting error it had overstated the company’s net worth by more than $1 billion. The two reports caused investors to lose confidence in Enron, and its stock price fell.

Meanwhile, the SEC began an investigation of Enron because some of the losses reported were due to complex partnerships. In November, Enron restated its earnings for the past four years, saying that its profits were $568 million less than it had previously announced. Enron’s stock fell still farther and Enron’s credit rating faltered. Lending to the company all but disappeared, while creditors demanded repayment. An attempt to survive by merging with another energy company, Dynegy, failed. Unable to pay its bills, Enron filed for Chapter 11 bankruptcy on December 2, 2001. Experts predicted that the company would not survive bankruptcy intact, its assets would be sold to satisfy creditors, and the firm would eventually disappear.