Enron scandal
The Enron scandal was an
Enron was formed in 1985 by
Many executives at Enron were indicted for a variety of charges and some were later sentenced to prison, including former CEO Jeffrey Skilling. Then CEO and Chairman Kenneth Lay was indicted and convicted, but died before being sentenced. Arthur Andersen LLC was found guilty of illegally destroying documents relevant to the SEC investigation, which voided its license to audit public companies and effectively closed the firm. By the time the ruling was overturned at the Supreme Court, Arthur Andersen had lost the majority of its customers and had ceased operating. Enron employees and shareholders received limited returns in lawsuits, despite losing billions in pensions and stock prices.
As a consequence of the scandal, new regulations and legislation were enacted to expand the accuracy of financial reporting for public companies.[4] One piece of legislation, the Sarbanes–Oxley Act, increased penalties for destroying, altering, or fabricating records in federal investigations or for attempting to defraud shareholders.[5] The act also increased the accountability of auditing firms to remain unbiased and independent of their clients.[4]
Rise of Enron
In 1985,
As Enron became the largest seller of natural gas in North America by 1992, its trading of gas contracts earned $122 million (before interest and taxes), the second largest contributor to the company's net income. The November 1999 creation of the
In an attempt to achieve further growth, Enron pursued a diversification strategy. The company owned and operated a variety of assets including gas pipelines, electricity plants, paper plants, water plants, and broadband services across the globe. Enron also gained additional revenue by trading contracts for the same array of products and services with which it was involved.[6]: 5 This included setting up power generation plants in developing countries and emerging markets including the Philippines (Subic Bay), Indonesia and India (Dabhol).[9]
Enron's stock increased from the start of the 1990s until year-end 1998 by 311%, only modestly higher than the average rate of growth in the
Causes of downfall
Enron's complex financial statements were confusing to shareholders and analysts.[1]: 6 [10] In addition, its complex business model and unethical practices required that the company use accounting limitations to misrepresent earnings and modify the balance sheet to indicate favorable performance.[6]: 9 Furthermore, some speculative business ventures proved disastrous.
The combination of these issues later resulted in the bankruptcy of Enron, and the majority of them were perpetuated by the indirect knowledge or direct actions of Lay,
Revenue recognition
Enron earned profits by providing services such as wholesale trading and risk management in addition to building and maintaining electric power plants, natural gas pipelines, storage, and processing facilities.[12] When accepting the risk of buying and selling products, merchants are allowed to report the selling price as revenues and the products' costs as cost of goods sold. In contrast, an "agent" provides a service to the customer, but does not take the same risks as merchants for buying and selling. Service providers, when classified as agents, may report trading and brokerage fees as revenue, although not for the full value of the transaction.[13]: 101–103
Although trading companies such as
Between 1996 and 2000, Enron's revenues increased by more than 750%, rising from $13.3 billion in 1996 to $100.7 billion in 2000. This expansion of 65% per year was extraordinary in any industry, including the energy industry, which typically considered growth of 2–3% per year to be respectable. For just the first nine months of 2001, Enron reported $138.7 billion in revenues, placing the company at the sixth position on the Fortune Global 500.[13]: 97–100
Enron also used
Mark-to-market accounting
In Enron's natural gas business, the accounting had been fairly straightforward: in each time period, the company listed actual costs of supplying the gas and actual revenues received from selling it. However, when Skilling joined Enron, he demanded that the trading business adopt mark-to-market accounting, claiming that it would represent "true economic value".[11]: 39–42 Enron became the first nonfinancial company to use the method to account for its complex long-term contracts.[18] Mark-to-market accounting requires that once a long-term contract has been signed, income is estimated as the present value of net future cash flow. Often, the viability of these contracts and their related costs were difficult to estimate.[6]: 10 Owing to the large discrepancies between reported profits and cash, investors were typically given false or misleading reports. Under this method, income from projects could be recorded, although the firm might never have received the money, with this income increasing financial earnings on the books. However, because in future years the profits could not be included, new and additional income had to be included from more projects to develop additional growth to appease investors.[11]: 39–42 As one Enron competitor stated, "If you accelerate your income, then you have to keep doing more and more deals to show the same or rising income."[18] Despite potential pitfalls, the U.S. Securities and Exchange Commission (SEC) approved the accounting method for Enron in its trading of natural gas futures contracts on January 30, 1992.[11]: 39–42 However, Enron later expanded its use to other areas in the company to help it meet Wall Street projections.[11]: 127
For one contract, in July 2000, Enron and
Special purpose entities
Enron used special purpose entities—limited partnerships or companies created to fulfill a temporary or specific purpose to fund or manage risks associated with specific assets. The company elected to disclose minimal details on its use of "special purpose entities".[6]: 11 These shell companies were created by a sponsor, but funded by independent equity investors and debt financing. For financial reporting purposes, a series of rules dictate whether a special purpose entity is a separate entity from the sponsor. In total, by 2001, Enron had used hundreds of special purpose entities to hide its debt.[6]: 10 The company used a number of special purpose entities, such as partnerships in its Thomas and Condor tax shelters, financial asset securitization investment trusts (FASITs) in the Apache deal, real estate mortgage investment conduits (REMICs) in the Steele deal, and REMICs and real estate investment trusts (REITs) in the Cochise deal.[21]
The special purpose entities were Tobashi schemes used for more than just circumventing accounting conventions. As a result of one violation, Enron's balance sheet understated its liabilities and overstated its equity, and its earnings were overstated.[6]: 11 Enron disclosed to its shareholders that it had hedged downside risk in its own illiquid investments using special purpose entities. However, investors were oblivious to the fact that the special purpose entities were actually using the company's own stock and financial guarantees to finance these hedges. This prevented Enron from being protected from the downside risk.[6]: 11
JEDI and Chewco
In 1993, Enron established a joint venture in energy investments with CalPERS, the California state pension fund, called the Joint Energy Development Investments (JEDI).[11]: 67 In 1997, Skilling, serving as Enron's chief operating officer (COO), asked CalPERS to join Enron in a separate investment. CalPERS was interested in the idea, but only if it could be terminated as a partner in JEDI.[1]: 30 However, Enron did not want to show any debt from assuming CalPERS' stake in JEDI on its balance sheet. Chief Financial Officer (CFO) Fastow developed the special purpose entity Chewco Investments, a limited partnership (L.P.) which raised debt guaranteed by Enron and was used to acquire CalPERS's joint venture stake for $383 million.[6]: 11 Because of Fastow's organization of Chewco, JEDI's losses were kept off of Enron's balance sheet.
In autumn 2001, CalPERS and Enron's arrangement was discovered, which required the discontinuation of Enron's prior accounting method for Chewco and JEDI. This disqualification revealed that Enron's reported earnings from 1997 to mid-2001 would need to be reduced by $405 million and that the company's indebtedness would increase by $628 million.[1]: 31
Whitewing
Whitewing was the name of a special purpose entity used as a financing method by Enron.[22] In December 1997, with funding of $579 million provided by Enron and $500 million by an outside investor, Whitewing Associates L.P. was formed. Two years later, the entity's arrangement was changed so that it would no longer be consolidated with Enron and be counted on the company's balance sheet. Whitewing was used to purchase Enron assets, including stakes in power plants, pipelines, stocks, and other investments.[23] Between 1999 and 2001, Whitewing bought assets from Enron worth $2 billion, using Enron stock as collateral. Although the transactions were approved by the Enron board, the asset transfers were not true sales and should have been treated instead as loans.[24]
LJM and Raptors
In 1999, Fastow formulated two limited partnerships: LJM Cayman. L.P. (LJM1) and LJM2 Co-Investment L.P. (LJM2), for the purpose of buying Enron's poorly performing stocks and stakes to improve its financial statements. LJM 1 and 2 were created solely to serve as the outside equity investor needed for the special purpose entities that were being used by Enron.
Enron transferred to "Raptor I-IV", four LJM-related special purpose entities named after the
Enron capitalized the Raptors, and, in a manner similar to the accounting employed when a company issues stock at a public offering, then booked the notes payable issued as assets on its balance sheet while increasing the shareholders' equity for the same amount.[1]: 38 This treatment later became an issue for Enron and its auditor Arthur Andersen, as removing it from the balance sheet resulted in a $1.2 billion decrease in net shareholders' equity.[27]
Eventually the derivative contracts worth $2.1 billion lost significant value. Swaps were established at the time the stock price achieved its maximum. During the ensuing year, the value of the portfolio under the swaps fell by $1.1 billion as the stock prices decreased (the loss of value meant that the special purpose entities technically now owed Enron $1.1 billion by the contracts). Enron, using its mark-to-market accounting method, claimed a $500 million gain on the swap contracts in its 2000 annual report. The gain was responsible for offsetting its stock portfolio losses and was attributed to nearly a third of Enron's earnings for 2000 (before it was properly restated in 2001).[1]: 39
Corporate governance
On paper, Enron had a model board of directors comprising predominantly outsiders with significant ownership stakes and a talented audit committee. In its 2000 review of best corporate boards, Chief Executive included Enron among its five best boards.[28]: 21 Even with its complex corporate governance and network of intermediaries, Enron was still able to "attract large sums of capital to fund a questionable business model, conceal its true performance through a series of accounting and financing maneuvers, and hype its stock to unsustainable levels."[6]: 4
Executive compensation
Although Enron's compensation and performance management system was designed to retain and reward its most valuable employees, the system contributed to a dysfunctional corporate culture that became obsessed with short-term earnings to maximize bonuses. Employees constantly tried to start deals, often disregarding the quality of cash flow or profits, in order to get a better rating for their performance review. Additionally, accounting results were recorded as soon as possible to keep up with the company's stock price. This practice helped ensure deal-makers and executives received large cash bonuses and stock options.[13]: 112
Enron was constantly emphasizing its stock price. Management was compensated extensively using
Skilling believed that if Enron employees were constantly worried about cost, it would hinder original thinking.[11]: 119 As a result, extravagant spending was rampant throughout the company, especially among the executives. Employees had large expense accounts and many executives were paid sometimes twice as much as competitors.[11]: 401 In 1998, the top 200 highest-paid employees received $193 million from salaries, bonuses, and stock. Two years later, the figure jumped to $1.4 billion.[11]: 241
Risk management
Before its demise, Enron was lauded for its sophisticated financial risk management tools.[30] Risk management was crucial to Enron not only because of its regulatory environment, but also because of its business plan. Enron established long-term fixed commitments which needed to be hedged to prepare for the invariable fluctuation of future energy prices.[31]: 1171 Enron's downfall was attributed to its reckless use of derivatives and special purpose entities. By hedging its risks with special purpose entities which it owned, Enron retained the risks associated with the transactions. This arrangement had Enron implementing hedges with itself.[28]: 17
Enron's aggressive accounting practices were not hidden from the board of directors, as later learned by a Senate subcommittee. The board was informed of the rationale for using the Whitewing, LJM, and Raptor transactions, and after approving them, received status updates on the entities' operations. Although not all of Enron's widespread improper accounting practices were revealed to the board, the practices were dependent on board decisions.[31]: 1170 Even though Enron extensively relied on derivatives for its business, the company's finance committee and board did not have enough experience with derivatives to understand what they were being told. The Senate subcommittee argued that had there been a detailed understanding of how the derivatives were organized, the board would have prevented their use.[31]: 1175
Financial audit
Enron's accounting firm, Arthur Andersen, was accused of applying reckless standards in its audits because of a conflict of interest over the significant consulting fees generated by Enron. During 2000, Andersen earned $25 million in audit fees and $27 million in consulting fees (this amount accounted for roughly 27% of the audit fees of public clients for Andersen's Houston office). The auditor's methods were questioned as either being completed solely to receive its annual fees or for its lack of expertise in properly reviewing Enron's revenue recognition, special entities, derivatives, and other accounting practices.[6]: 15
Enron hired numerous
Andersen's auditors were pressured by Enron's management to defer recognizing the charges from the special purpose entities as its
Revelations concerning Andersen's overall performance led to the break-up of the firm, and to the following assessment by the Powers Committee (appointed by Enron's board to look into the firm's accounting in October 2001): "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".[33]
Audit committee
Corporate audit committees usually meet just a few times during the year, and their members typically have only modest experience with accounting and finance. Enron's audit committee had more expertise than many others. It included:[34]
- Stanford Business School
- M.D. Anderson Cancer Center
- Paulo Pereira, former president and CEO of the State Bank of Rio de Janeiro in Brazil
- John Wakeham, former United Kingdom Secretary of State for Energy and Parliamentary Secretary to the Treasury
- Ronnie Chan, Chairman of Hong Kong Hang Lung Group
- Wendy Gramm, former Chair of U.S. Commodity Futures Trading Commission
Enron's audit committee was later criticized for its brief meetings that would cover large amounts of material. In one meeting on February 12, 2001, the committee met for an hour and a half. Enron's audit committee did not have the technical knowledge to question the auditors properly on accounting issues related to the company's special purpose entities. The committee was also unable to question the company's management due to pressures on the committee.[6]: 14 The United States Senate Permanent Subcommittee on Investigations of the Committee on Governmental Affairs' report accused the board members of allowing conflicts of interest to impede their duties as monitoring the company's accounting practices. When Enron's scandal became public, the audit committee's conflicts of interest were regarded with suspicion.[35]
Ethical and political analyses
Commentators attributed the mismanagement behind Enron's fall to a variety of ethical and political-economic causes. Ethical explanations centered on executive greed and hubris, a lack of corporate social responsibility, situation ethics, and get-it-done business pragmatism.[36][37][38][39][40] Political-economic explanations cited post-1970s deregulation, and inadequate staff and funding for regulatory oversight.[41][42] A more libertarian analysis maintained that Enron's collapse resulted from the company's reliance on political lobbying, rent-seeking, and the gaming of regulations.[43]
Other accounting issues
Enron made a habit of booking costs of cancelled projects as assets, with the rationale that no official letter had stated that the project was cancelled. This method was known as "the snowball", and although it was initially dictated that such practices be used only for projects worth less than $90 million, it was later increased to $200 million.[11]: 77
In 1998, when analysts were given a tour of the
Speculative business ventures
Enron division Azurix, slated for an
Timeline of downfall
At the beginning of 2001, the Enron Corporation, the world's dominant energy trader, appeared unstoppable. The company's decade-long effort to persuade lawmakers to deregulate electricity markets had succeeded from California to New York. Its ties to the Bush administration assured that its views would be heard in Washington. Its sales, profits and stock were soaring.
—A. Berenson and R. A. Oppel, Jr. The New York Times, October 28, 2001.[45]
On September 20, 2000, a reporter at
In February 2001,
McLean telephoned Skilling to discuss her findings prior to publishing the article, but he called her "unethical" for not properly researching his company.[48] Fastow claimed that Enron could not reveal earnings details as the company had more than 1,200 trading books for assorted commodities and did "... not want anyone to know what's on those books. We don't want to tell anyone where we're making money."[46]
In a conference call on April 17, 2001, then-Chief Executive Officer (CEO) Skilling verbally attacked Wall Street analyst Richard Grubman,[49] who questioned Enron's unusual accounting practices during a recorded conference call. When Grubman complained that Enron was the only company that could not release a balance sheet along with its earnings statements, Skilling stammered, "Well uh ... Thank you very much, we appreciate it ... Asshole."[50] This became an inside joke among many Enron employees, mocking Grubman for his perceived meddling rather than Skilling's offensiveness, with slogans such as, "Ask Why, Asshole", a variation on Enron's official slogan "Ask why".[51] However, Skilling's comment was met with dismay and astonishment by press and public, as he had previously disdained criticism of Enron coolly or humorously.[citation needed]
By the late 1990s Enron's stock was trading for $80–90 per share, and few seemed to concern themselves with the opacity of the company's financial disclosures. In mid-July 2001, Enron reported revenues of $50.1 billion, almost triple year-to-date, and beating analysts' estimates by 3 cents a share.[52] Despite this, Enron's profit margin had stayed at a modest average of about 2.1%, and its share price had decreased by more than 30% since the same quarter of 2000.[52]
As time passed, a number of serious concerns confronted the company. Enron had recently faced several serious operational challenges, namely logistical difficulties in operating a new broadband communications trading unit, and the losses from constructing the
There are no accounting issues, no trading issues, no reserve issues, no previously unknown problem issues. I think I can honestly say that the company is probably in the strongest and best shape that it has probably ever been in.
—Kenneth Lay answering an analyst's question on August 14, 2001.[11]: 347
On August 14, Skilling announced he was resigning his position as CEO after only six months citing personal reasons.[54] Observers noted that in the months before his exit, Skilling had sold at minimum 450,000 shares of Enron at a value of around $33 million (though he still owned over a million shares at the date of his departure).[54] Nevertheless, Lay, who was serving as chairman at Enron, assured surprised market watchers that there would be "no change in the performance or outlook of the company going forward" from Skilling's departure.[54] Lay announced he himself would re-assume the position of chief executive officer.[citation needed]
On August 15,
Investors' confidence declines
Something is rotten with the state of Enron.
—The New York Times, September 9, 2001.[58]
By the end of August 2001, his company's stock value still falling, Lay named Greg Whalley, president and COO of Enron Wholesale Services, to succeed Skilling as president and COO of the entire company. He also named Mark Frevert as vice chairman, and appointed Whalley and Frevert to positions in the chairman's office. Some observers suggested that Enron's investors were in significant need of reassurance, not only because the company's business was difficult to understand (even "indecipherable")[58] but also because it was difficult to properly describe the company in financial statements.[59] One analyst stated "it's really hard for analysts to determine where [Enron] are making money in a given quarter and where they are losing money."[59] Lay accepted that Enron's business was very complex, but asserted that analysts would "never get all the information they want" to satisfy their curiosity. He also explained that the complexity of the business was due largely to tax strategies and position-hedging.[59] Lay's efforts seemed to meet with limited success; by September 9, one prominent hedge fund manager noted that "[Enron] stock is trading under a cloud."[58] The sudden departure of Skilling combined with the opacity of Enron's accounting books made proper assessment difficult for Wall Street. In addition, the company admitted to repeatedly using "related-party transactions", which some feared could be too easily used to transfer losses that might otherwise appear on Enron's own balance sheet. A particularly troubling aspect of this technique was that several of the "related-party" entities had been or were being controlled by CFO Fastow.[58]
After the
Restructuring losses and SEC investigation
On October 16, 2001, Enron announced that restatements to its financial statements for years 1997 to 2000 were necessary to correct accounting violations. The restatements for the period reduced earnings by $613 million (or 23% of reported profits during the period), increased liabilities at the end of 2000 by $628 million (6% of reported liabilities and 5.5% of reported equity), and reduced equity at the end of 2000 by $1.2 billion (10% of reported equity).
Enron's management team claimed the losses were mostly due to investment losses, along with charges such as about $180 million in money spent restructuring the company's troubled broadband trading unit. In a statement, Lay said, "After a thorough review of our businesses, we have decided to take these charges to clear away issues that have clouded the performance and earnings potential of our core energy businesses."[61] Some analysts were unnerved. David Fleischer at Goldman Sachs, an analyst termed previously 'one of the company's strongest supporters' asserted that the Enron management "... lost credibility and have to reprove themselves. They need to convince investors these earnings are real, that the company is for real and that growth will be realized."[61][62]
Fastow disclosed to Enron's board of directors on October 22 that he earned $30 million from compensation arrangements when managing the LJM limited partnerships. That day, the share price of Enron decreased to $20.65, down $5.40 in one day, after the announcement by the SEC that it was investigating several suspicious deals struck by Enron, characterizing them as "some of the most opaque transactions with insiders ever seen".[63] Attempting to explain the billion-dollar charge and calm investors, Enron's disclosures spoke of "share settled costless collar arrangements", "derivative instruments which eliminated the contingent nature of existing restricted forward contracts," and strategies that served "to hedge certain merchant investments and other assets." Such puzzling phraseology left many analysts feeling ignorant about just how Enron managed its business.[63] Regarding the SEC investigation, chairman and CEO Lay said, "We will cooperate fully with the SEC and look forward to the opportunity to put any concern about these transactions to rest."[63]
Two days later, on October 25, Fastow was removed as CFO, despite Lay's assurances as early as the previous day that he and the board had confidence in him. In announcing Fastow's ouster, Lay said, "In my continued discussions with the financial community, it became clear to me that restoring investor confidence would require us to replace Andy as CFO."[64] The move came after several banks refused to issue loans to Enron as long as Fastow remained CFO.[44] However, with Skilling and Fastow now both departed, some analysts feared that revealing the company's practices would be made all the more difficult.[64] Enron's stock was now trading at $16.41, having lost half its value in a little more than a week.[64]
Jeff McMahon, head of industrial markets, succeeded Fastow as CFO. His first task was to deal with a cash crisis. A day earlier, Enron discovered that it was unable to roll its
As the month came to a close, serious concerns were being raised by some observers regarding Enron's possible manipulation of accepted accounting rules; however, analysis was claimed to be impossible based on the incomplete information provided by Enron.[66] Industry analysts feared that Enron was the new Long-Term Capital Management, the hedge fund whose bankruptcy in 1998 threatened systemic failure of the international financial markets. Enron's tremendous presence worried some about the consequences of the company's possible bankruptcy.[45] Enron executives accepted questions in written form only.[45]
Credit rating downgrade
The main short-term danger to Enron's survival at the end of October 2001 seemed to be its credit rating. It was reported at the time that
Analysts and observers continued their complaints regarding the difficulty or impossibility of properly assessing a company whose financial statements were so cryptic. Some feared that no one at Enron apart from Skilling and Fastow could completely explain years of mysterious transactions. "You're getting way over my head", said Lay during late August 2001 in response to detailed questions about Enron's business, a reaction that worried analysts.[45]
On October 29, responding to growing concerns that Enron might have insufficient cash on hand, news spread that Enron was seeking a further $1–2 billion in financing from banks.
November began with the disclosure that the SEC was now pursuing a formal investigation, prompted by questions related to Enron's dealings with "related parties". Enron's board also announced that it would commission a special committee to investigate the transactions, directed by
Proposed buyout by Dynegy
Sources claimed that Enron was planning to explain its business practices more fully within the coming days, as a confidence-building gesture.[72] Enron's stock was now trading at around $7, and by this time it was obvious that Enron could not stay independent. However, investors worried that the company would not be able to find a buyer.[citation needed]
After Enron had received a wide spectrum of rejections, Enron management apparently found a buyer when the board of Dynegy, another energy trader based in Houston, voted late at night on November 7 to acquire Enron at a very low price of about $8 billion in stock.[73] Chevron Texaco, which at the time owned about a quarter of Dynegy, agreed to provide Enron with $2.5 billion in cash, specifically $1 billion at first and the rest when the deal was completed. Dynegy would also be required to assume nearly $13 billion of debt, plus any other debt hitherto occluded by the Enron management's secretive business practices,[73] possibly as much as $10 billion in "hidden" debt.[74] Dynegy and Enron confirmed their deal on November 8, 2001.[citation needed]
With Enron in a state of near collapse, the deal was largely on Dynegy's terms. Dynegy would be the surviving company, and Dynegy CEO Charles Watson and his management team would head the merged company. Enron shareholders would get a 40 percent stake in the enlarged Dynegy, and Enron would get three seats on the merged company's board. Lay would not have any management role, though it was presumed he would get one of Enron's seats on the board. Of Enron's senior executives, only Whalley would join the merged company's C-suite, as an executive vice president. Dynegy agreed to invest $1.5 billion into Enron to keep it alive until the deal closed.[44][11]: 395
As a measure of how dire Enron's financial picture had become, the company initially balked at paying its bills for November until the credit agencies gave the merger their blessing and allowed Enron to keep its credit at investment grade. By this time, the Dynegy deal was virtually the only thing keeping the company alive, and Enron officials wanted to keep as much cash in the company's coffers in the event of bankruptcy.[44] Had the credit agencies balked at the deal and reduced Enron to junk status, its ability to trade would be severely limited if there was a reduction or elimination of its credit lines with competitors.[75][44] Ultimately, after Enron and Dynegy retooled the deal to make it harder for Dynegy to trigger the "material adverse change" clause and pull out, Moody's and S&P agreed to drop Enron to one notch above junk status, allowing Enron to pay its bills one day late with interest.[44]
Commentators remarked on the different corporate cultures between Dynegy and Enron, and on Watson's "straight-talking" personality.[8] Some wondered if Enron's troubles had not simply been the result of innocent accounting errors.[76] By November, Enron was asserting that the billion-plus "one-time charges" disclosed in October should in reality have been $200 million, with the rest of the amount simply corrections of dormant accounting mistakes.[77] Many feared other "mistakes" and restatements might yet be revealed.[75]
Another major correction of Enron's earnings was announced on November 9, with a reduction of $591 million of the stated revenue of years 1997–2000. The charges were said to come largely from two special purpose partnerships (JEDI and Chewco). The corrections resulted in the virtual elimination of profit for fiscal year 1997, with significant reductions for the other years. Despite this disclosure, Dynegy declared it still intended to purchase Enron.
Both companies promoted the deal aggressively, and some observers were hopeful; Watson was praised for attempting to create the largest company on the energy market.[75] At the time, Watson said: "We feel [Enron] is a very solid company with plenty of capacity to withstand whatever happens the next few months."[75] One analyst called the deal "a whopper ... a very good deal financially, certainly should be a good deal strategically, and provides some immediate balance-sheet backstop for Enron."[78]
Credit issues were becoming more critical, however. Around the time the buyout was made public, Moody's and S&P publicly announced that they had reduced Enron to just above junk status.[75] In a conference call, S&P affirmed that, were Enron not to be bought, S&P would reduce its rating to low BB or high B, ratings noted as being within junk status.[79] Additionally, many traders had limited their involvement with Enron, or stopped doing business altogether, fearing more bad news. Watson again attempted to re-assure, attesting at a presentation to investors that there was "nothing wrong with Enron's business".[78] He also acknowledged that remunerative steps (in the form of more stock options) would have to be taken to redress the animosity of many Enron employees towards management after it was revealed that Lay and other officials had sold hundreds of millions of dollars' worth of stock during the months prior to the crisis.[78] The situation was not helped by the disclosure that Lay, his "reputation in tatters",[80] stood to receive a payment of $60 million as a change-of-control fee subsequent to the Dynegy acquisition, while many Enron employees had seen their retirement accounts, which were based largely on Enron stock, ravaged as the price decreased 90% in a year. An official at a company owned by Enron stated "We had some married couples who both worked who lost as much as $800,000 or $900,000. It pretty much wiped out every employee's savings plan."[81]
Watson assured investors that the true nature of Enron's business had been made apparent to him: "We have comfort there is not another shoe to drop. If there is no shoe, this is a phenomenally good transaction."[79] Watson further asserted that Enron's energy trading part alone was worth the price Dynegy was paying for the whole company.[82]
By mid-November, Enron announced it was planning to sell about $8 billion worth of underperforming assets, along with a general plan to reduce its scale for the sake of financial stability.[83] On November 19 Enron disclosed to the public further evidence of its critical state of affairs, most pressingly that the company had debt repayment obligations in the range of $9 billion by the end of 2002. Such debts were "vastly in excess" of its available cash.[84] Also, the success of measures to preserve its solvency were not guaranteed, specifically as regarded asset sales and debt refinancing. In a statement, Enron revealed "An adverse outcome with respect to any of these matters would likely have a material adverse impact on Enron's ability to continue as a going concern."[84]
Two days later, on November 21, Wall Street expressed serious doubts that Dynegy would proceed with its deal at all, or would seek to radically renegotiate. Furthermore, Enron revealed in a 10-Q filing that almost all the money it had recently borrowed for purposes including buying its commercial paper, or about $5 billion, had been exhausted in just 50 days. Analysts were unnerved at the revelation, especially since Dynegy was reported to have also been unaware of Enron's rate of cash use.[85] In order to end the proposed buyout, Dynegy would need to legally demonstrate a "material change" in the circumstances of the transaction; as late as November 22, sources close to Dynegy were skeptical that the latest revelations constituted sufficient grounds.[86] Indeed, while Lay assumed that one of his underlings had shared the 10-Q with Dynegy officials, no one at Dynegy saw it until it was released to the public. It subsequently emerged that Enron's traders had grabbed much of the money from Dynegy's cash infusion and used it to guarantee payment to their trading partners when it came time to settle up.[44]
The SEC announced it had filed civil fraud complaints against Andersen.[87] A few days later, sources claimed Enron and Dynegy were renegotiating the terms of their arrangement.[88] Dynegy now demanded Enron agree to be bought for $4 billion rather than the previous $8 billion. Observers were reporting difficulties in ascertaining which of Enron's operations, if any, were profitable. Reports described an en masse shift of business to Enron's competitors for the sake of risk exposure reduction.[88]
Bankruptcy
On November 28, 2001, Enron's two worst possible outcomes came true. Credit rating agencies all reduced Enron's credit rating to junk status, and Dynegy's board tore up the merger agreement on Watson's advice. Watson later said, "At the end, you couldn't give it [Enron] to me."[11]: 403 Although they had seemingly ironed out a number of outstanding issues at a meeting in New York over the previous weekend, ultimately Dynegy's concerns about Enron's liquidity and dwindling business proved insurmountable.[44] The company had very little cash with which to operate, let alone satisfy enormous debts. Its stock price fell to $0.61 at the end of the day's trading. One editorial observer wrote that "Enron is now shorthand for the perfect financial storm."[89]
Systemic consequences were felt, as Enron's creditors and other energy trading companies suffered the loss of several percentage points. Some analysts felt Enron's failure indicated the risks of the post-September 11 economy, and encouraged traders to lock in profits where they could.[90] The question now became how to determine the total exposure of the markets and other traders to Enron's failure. Early calculations estimated $18.7 billion. One adviser stated, "We don't really know who is out there exposed to Enron's credit. I'm telling my clients to prepare for the worst."[91]
Within 24 hours, speculation abounded that Enron would have no choice but to file for bankruptcy. Enron was estimated to have about $23 billion in liabilities from both debt outstanding and guaranteed loans.
By the close of business on November 30, 2001, it was obvious Enron was at the end of its tether. That day, Enron Europe, the holding company for Enron's operations in
In its accounting work for Enron, Andersen had been sloppy and weak. But that's how Enron had always wanted it. In truth, even as they angrily pointed fingers, the two deserved each other.
—Bethany McLean and Peter Elkind in The Smartest Guys in the Room[11]: 393
On January 17, 2002, Enron dismissed Arthur Andersen as its auditor, citing its accounting advice and the destruction of documents. Andersen countered that it had already ended its relationship with the company when Enron became bankrupt.[97]
Trials
Enron
Fastow and his wife, Lea, both pleaded guilty to charges against them. Fastow was initially charged with 98 counts of fraud, money laundering, insider trading, and conspiracy, among other crimes.[98] Fastow pleaded guilty to two charges of conspiracy and was sentenced to ten years with no parole in a plea bargain to testify against Lay, Skilling, and Causey.[99] Lea was indicted on six felony counts, but prosecutors later dismissed them in favor of a single misdemeanor tax charge. Lea was sentenced to one year for helping her husband hide income from the government.[100]
Lay and Skilling went on trial for their part in the Enron scandal in January 2006. The 53-count, 65-page indictment covers a broad range of financial crimes, including bank fraud, making false statements to banks and auditors, securities fraud, wire fraud, money laundering, conspiracy, and insider trading. United States District Judge Sim Lake had previously denied motions by the defendants to have separate trials and to relocate the case out of Houston, where the defendants argued the negative publicity concerning Enron's demise would make it impossible to get a fair trial. On May 25, 2006, the jury in the Lay and Skilling trial returned its verdicts. Skilling was convicted of 19 of 28 counts of securities fraud and wire fraud and acquitted on the remaining nine, including charges of insider trading. He was sentenced to 24 years and 4 months in prison.[101] In 2013 the United States Department of Justice reached a deal with Skilling, which resulted in ten years being cut from his sentence.[102]
Lay pleaded not guilty to the eleven criminal charges, and claimed that he was misled by those around him. He attributed the main cause for the company's demise to Fastow.[103] Lay was convicted of all six counts of securities and wire fraud for which he had been tried, and he was subject to a maximum total sentence of 45 years in prison.[104] However, before sentencing was scheduled, Lay died on July 5, 2006. At the time of his death, the SEC had been seeking more than $90 million from Lay in addition to civil fines. The case of Lay's wife, Linda, is a difficult one. She sold roughly 500,000 shares of Enron ten minutes to thirty minutes before the information that Enron was collapsing went public on November 28, 2001.[105] Linda was never charged with any of the events related to Enron.[106]
Although Michael Kopper worked at Enron for more than seven years, Lay did not know of Kopper even after the company's bankruptcy. Kopper was able to keep his name anonymous in the entire affair.[11]: 153 Kopper was the first Enron executive to plead guilty.[107] was indicted with six felony charges for disguising Enron's financial condition during his tenure.[108] After pleading not guilty, he later switched to guilty and was sentenced to seven years in prison.[109]
All told, sixteen people pleaded guilty for crimes committed at the company,
Michael W. Krautz, a former Enron accountant, was among the accused who was acquitted
Arthur Andersen
Arthur Andersen was charged with and found guilty of obstruction of justice for shredding the thousands of documents and deleting e-mails and company files that tied the firm to its audit of Enron.[117] Although only a small number of Arthur Andersen's employees were involved with the scandal, the firm was effectively put out of business; the SEC is not allowed to accept audits from convicted felons. The company surrendered its CPA license on August 31, 2002, and 85,000 employees lost their jobs.[118][119] The conviction was later overturned by the U.S. Supreme Court due to the jury not being properly instructed on the charge against Andersen.[120] The Supreme Court ruling theoretically left Andersen free to resume operations. However, the damage to the Andersen name has been so great that it has not returned as a viable business even on a limited scale.
NatWest Three
Giles Darby, David Bermingham, and Gary Mulgrew worked for
Aftermath
While some employees, like John D. Arnold, received large bonuses in the final days of the company,[128] Enron's shareholders lost $74 billion in the four years before the company's bankruptcy ($40 to $45 billion was attributed to fraud).[129] As Enron had nearly $67 billion that it owed creditors and shareholders received limited, if any, assistance aside from severance from Enron.[130] To pay its creditors, Enron was legally ordered to sell assets including art, photographs, logo signs, and its pipelines.[131][132][133]
A
In May 2004, more than 20,000 of Enron's former employees won a suit of $85 million for compensation of $2 billion that was lost from their pensions. From the settlement, the employees each received about $3,100.
Sarbanes–Oxley Act
In the Titanic, the captain went down with the ship. And Enron looks to me like the captain first gave himself and his friends a bonus, then lowered himself and the top folks down the lifeboat and then hollered up and said, "By the way, everything is going to be just fine."
—U.S. Senator Byron Dorgan[139]
Between December 2001 and April 2002, the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial Services held multiple hearings about the Enron scandal and related accounting and investor protection issues. These hearings and the corporate scandals that followed Enron led to the passage of the Sarbanes-Oxley Act on July 30, 2002.[140] The Act is nearly "a mirror image of Enron: the company's perceived corporate governance failings are matched virtually point for point in the principal provisions of the Act."[141]
The main provisions of the Sarbanes–Oxley Act included the establishment of the
On February 13, 2002, due to the instances of corporate malfeasances and accounting violations, the SEC recommended changes of the stock exchanges' regulations. In June 2002, the New York Stock Exchange announced a new governance proposal, which was approved by the SEC in November 2003. The main provisions of the final NYSE proposal include:[140]
- All companies must have a majority of independent directors.
- Independent directors must comply with an elaborate definition of independent directors.
- The compensation committee, nominating committee, and audit committee shall consist of independent directors.
- All audit committee members should be financially literate. In addition, at least one member of the audit committee is required to have accounting or related financial management expertise.
- In addition to its regular sessions, the board should hold additional sessions without management.
Criticism of the Bush administration
Kenneth Lay was a longtime supporter of U.S. president
In an article that same month,
See also
- The Crooked E: The Unshredded Truth About Enron – television film about the rise and fall of Enron, based on Anatomy of Greed, a 2002 book by an ex-employee
- Enron: The Smartest Guys in the Room – 2005 documentary based on the eponymous 2003 book about the scandal
- Law & Order: Criminal Intent episode "Tuxedo Hill" – 2002 television episode inspired by the Enron Scandal
- ENRON – 2009 play by British playwright Lucy Prebble about the scandal
- Arthur Andersen LLP v. United States – conviction in United States District Court subsequently overturned by United States Supreme Court
- The Enron Corpus – a database of more than 600,000 emails between Enron executives, made public and used extensively in social networking research
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- ISBN 978-1-59184-008-4.
- Dharan, Bala G.; William R. Bufkins (2004). Enron: Corporate Fiascos and Their Implications. ISBN 978-1-58778-578-8.
Further reading
- Bryce, Robert (December 17, 2008). Pipe Dreams: Greed, Ego, and the Death of Enron. ISBN 978-1-58648-201-5.
- Collins, Denis (May 24, 2006). Behaving Badly: Ethical Lessons from Enron. Dog Ear Publishing, LLC. ISBN 978-1-59858-160-7.
- Cruver, Brian (September 1, 2003). Anatomy of Greed: Telling the Unshredded Truth from Inside Enron. ISBN 978-0-7867-1205-2.
- Eichenwald, Kurt (December 27, 2005). Conspiracy of Fools: A True Story. ISBN 978-0-7679-1179-5.
- Fox, Loren (December 22, 2003). Enron: The Rise and Fall. ISBN 978-0-471-47888-1.
- Fusaro, Peter C.; Ross M. Miller (June 21, 2002). What Went Wrong at Enron: Everyone's Guide to the Largest Bankruptcy in U.S. History. ISBN 978-0-471-26574-0.
- Salter, Malcolm S. (June 30, 2008). Innovation Corrupted: The Origins and Legacy of Enron's Collapse. ISBN 978-0-674-02825-8.
- Swartz, Mary; Sherron Watkins (March 9, 2004). Power Failure: The Inside Story of the Collapse of Enron. ISBN 978-0-7679-1368-3.
External links
- The short film Enron Bankruptcy (February 7, 2002) is available for free viewing and download at the Internet Archive.
- Documentary series from Court TV (now TruTV) "MUGSHOTS: Enron – Wall Street Scammers" episode (2002) at FilmRise