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.

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.

V.

Enron Investigations

The collapse of one of the nation’s largest and presumably best-run companies brought intense media and governmental scrutiny. A dozen congressional committees held hearings on Enron. The Department of Justice created an Enron task force, including investigators from the Federal Bureau of Investigation and the Internal Revenue Service, to look for evidence of fraud and insider trading, the illegal practice of buying or selling stocks or other securities based on privileged information not available to the public.

Investigators sought to learn whether Enron’s senior executives defrauded investors by deliberately concealing negative information about its finances. The insider trading allegations centered upon the sale by senior Enron executives of company stock and their exercise of Enron stock options before the stock price plunged.

The media focused on Enron’s role in the California energy crisis, the period during 2001 when a shortage of electricity led to increased electric utility rates for California consumers. Using strategies given names such as Death Star and Load Shift, Enron appeared to have deliberately created the appearance of congestion on the California power grid so that it would be paid to alleviate the congestion. Some media investigations alleged that Enron bought energy at a lower, government-capped price in California and then sold it elsewhere. Enron officials claimed that the company did nothing wrong in California, although it made enormous profits in energy trading during late 2000 and early 2001. Meanwhile some Californians had to pay twice as much per kilowatt-hour for energy and endure rolling brownouts (cutbacks in power) when utilities could not meet the state’s demand for energy.

VI.

Enron’s “Creative Accounting”

How did Enron fool so many for so long? Among those left holding Enron stock or debt were major pension funds and investment banks, regarded as the shrewdest investors around. To avoid reporting its mounting losses and to give the appearance of rapid earnings growth, Enron undertook creative accounting. For example, it priced the value of its deepwater drilling operations higher than what its reserves merited. It claimed that contracts due in the future were worth more than they were. And most famously, it hid losses in partnerships, or what were legally called “special purpose entities” (SPEs).

SPEs reflect a common financing technique for companies. Companies can cut their risk by moving assets into separate partnerships that can be sold to outside investors. In Enron’s case, assets that were losing money were sold to partnerships. Enron listed the sales of these assets as earnings. However, to be legitimate, accounting rules require that an SPE be legally isolated from the company that created it. In Enron’s case this was not true. The SPEs relied upon Enron managers for leadership and Enron stock for capital. When outside auditors told Enron to treat some of the 4,000 SPEs it had created as part of Enron, the company had to take the $1-billion charge against earnings.

Where were Enron’s audit committee and its external auditing firm, Arthur Andersen LLP? These bodies were responsible for assuring investors and the public that the firm’s financial statements were full and accurate. Apparently, the company’s audit committee in particular and the company’s board of directors in general failed to meet their responsibility because they lacked enough information about Enron’s complicated financial maneuvers. Moreover, they had close ties to management and received ample compensation for their service, so they apparently felt little incentive to ask difficult questions.

The external auditing firm, Arthur Andersen, failed to act in part because it made more money providing consulting services for Enron than it did providing auditing services. When challenged by the federal government in court, Andersen claimed it was not responsible because it could only work with the numbers provided by the company. However, a jury found the firm guilty of obstructing justice in June 2002 for destroying documents in anticipation of an SEC investigation. Andersen was one of the earliest casualties of the Enron scandal, as it lost its major accounts and ceased to be one of the world’s five largest accounting firms.

VII.

Executive Enrichment

In the year before declaring bankruptcy, Enron paid 140 of its managers about $680 million. Lay, who had stepped down as CEO to become Enron’s chairman in December 2000, took home $67 million, while Skilling received $42 million. Some of this income reflected sale of stock just before Enron nosedived, which struck observers as doubly wrong since these executives caused the company’s failure and then cashed out early when the company’s stock was still high.

Lower-level employees were not as fortunate. Their pensions were in the form of a defined contribution retirement plan known as a 401(k), in which the company matched their savings with Enron stock. This stock could not be sold before the employee turned age 50. Even as warnings about the company’s financing surfaced, Enron executives, citing rapid growth and healthy earnings, encouraged employees to invest more of their 401(k) savings in Enron stock.

The average Enron worker had 62 percent of his or her 401(k) savings in Enron stock. When the stock price fell from a high of $90 to less than $1 a share, most Enron workers found their retirement funds just about wiped out. Further, while Enron’s stock plummeted, the 401(k) plan was “locked down” during an administrative “blackout period,” prohibiting those over age 50 from selling their shares. This prohibition, however, did not apply to executives who owned shares or controlled stock options.

VIII.

Repercussions of the Scandal

The Enron scandal shook America’s stock markets, which were already slumping. Investors feared that other companies engaged in fraudulent accounting practices, and their fears were realized when scandal hit several leading telecommunications firms. From 2000 to mid-2002 prices of stocks for the nation’s largest companies fell by more than 33 percent, while technology stocks dropped 70 percent. More than 700 companies had to restate earnings from the previous five years, tacit admissions that they, too, engaged in creative accounting. Perhaps one-fourth of operating earnings by the top 500 companies from 1997 to 2000 was the result of accounting shenanigans.

Corporate executives in some of these companies prospered even as their company’s stock sank. Some executives received huge personal loans from their companies on favorable terms, many received immense grants of stock and stock options, and most enjoyed what were known as “golden parachutes” (generous separation pay and retirement benefits). A couple of very large firms, WorldCom, Inc. and Global Crossing, went bankrupt in the wake of accounting scandals.

The Enron scandal also compromised the reputation of Wall Street stock analysts. As late as November 2001, less than a month before Enron filed for bankruptcy, 13 of the 16 analysts who covered Enron still told investors to buy Enron stock even though the company had reported a staggering $1.1-billion revision in its net worth the previous month and was undergoing an SEC probe. Not surprisingly, investors wondered whether they could trust corporations, auditors, or stock analysts.

IX.

Enron’s Legacy

Enron’s legacy may be widespread reform of corporate behavior. In July 2002 the U.S. Congress passed the Public Company Accounting Reform and Investor Protection Act. The new law created the Public Company Accounting Oversight Board under the SEC’s supervision. The board was given the power to set accounting standards and to investigate whether companies and certified public accounting (CPA) firms are conforming to the standards. The board also had the power to fine certified public accountants (CPAs) and their firms for violations, suspend CPAs and their firms, and recommend criminal investigations by the Justice Department. The new law also required CPA firms to separate their consulting and auditing services in order to avoid conflicts of interest like those in the Enron scandal.

Under the new legislation, chief executive officers and chief financial officers (CFOs) of publicly traded companies of a designated size are required to verify the accuracy of financial statements or risk going to prison for “willfully and knowingly” filing inaccurate statements.

The SEC also announced stiffer disclosure rules for publicly traded companies. Deadlines for reporting information were tightened, such as trading in company stock by executives, off-balance-sheet financing, and losses large enough to affect a company’s earnings. Finally, the conviction of Arthur Andersen for obstruction of justice and the probable demise of this top-five firm was expected to influence how the remaining big four auditing firms behave.

The Enron task force succeeded in securing guilty pleas from 16 of Enron’s former executives, including its former chief financial officer Andrew Fastow. In May 2006 a federal jury convicted Skilling on 19 of 28 counts of fraud and conspiracy. The same jury convicted Lay on all 6 of the fraud and conspiracy charges that he faced, and in a separate trial Lay was also found guilty by a federal judge of bank fraud charges. Both men faced maximum prison sentences totaling more than 160 years each.

The Enron scandal reminded Americans that a capitalist economy needs full and fair disclosure. Many observers blamed the swift and brutal collapse of Enron on executives who sought only to enrich themselves. The reason it became a national scandal, however, was that those who could have helped check the executives’ conduct—the auditors, analysts, and government regulators responsible for monitoring Enron’s activities—failed to do so. See also History of United States Business and Accounting and Bookkeeping.