Enron Scandal: The Fall of a Wall Street Darling

The story of Enron Corp. depicts a company that reached dramatic heights only to face a dizzying fall. The fated company’s collapse affected thousands of employees and shook Wall Street to its core. At Enron’s peak, its shares were worth $90.75; just prior to declaring bankruptcy on Dec. 2, 2001, they were trading at $0.26.

To this day, many wonder how such a powerful business—at the time one of the largest companies in the United States—disintegrated almost overnight. Also difficult to fathom is how its leadership managed to fool regulators for so long with fake holdings and off-the-books accounting. 

Enron’s Energy Origins

Enron was formed in 1985 following a merger between Houston Natural Gas Co. and Omaha, Neb.-based InterNorth Inc. Following the merger, Kenneth Lay, who had been the chief executive officer (CEO) of Houston Natural Gas, became Enron’s CEO and chair. Lay quickly rebranded Enron into an energy trader and supplier. Deregulation of the energy markets allowed companies to place bets on future prices, and Enron was poised to take advantage. In 1990, Lay created Enron Finance Corp. and appointed Jeffrey Skilling, whose work as a McKinsey & Co. consultant had impressed Lay, to head the new corporation. Skilling was then one of the youngest partners at McKinsey. 

Skilling joined Enron at an auspicious time. The era’s minimal regulatory environment allowed Enron to flourish. At the end of the 1990s, the dot-com bubble was in full swing, and the Nasdaq hit 5,000. Revolutionary Internet stocks were being valued at preposterous levels and, consequently, most investors and regulators simply accepted spiking share prices as the new normal.

Mark-to-Market

One of Skilling’s early contributions was to transition Enron’s accounting from a traditional historical cost accounting method to a mark-to-market (MTM) accounting method, for which the company received official U.S. Securities and Exchange Commission (SEC) approval in 1992. MTM is a measure of the fair value of accounts that can change over time, such as assets and liabilities. MTM aims to provide a realistic appraisal of an institution’s or company’s current financial situation, and it is a legitimate and widely used practice. However, in some cases, the method can be manipulated, since MTM is not based on “actual” cost but on “fair value,” which is harder to pin down. Some believe MTM was the beginning of the end for Enron, as it essentially permitted the organization to log estimated profits as actual profits.

Enron Hailed for Its Innovation

Enron created EnronOnline (EOL) in October 1999, an electronic trading website that focused on commodities. Enron was the counterparty to every transaction on EOL; it was either the buyer or the seller. To entice participants and trading partners, Enron offered its reputation, credit, and expertise in the energy sector. Enron was praised for its expansions and ambitious projects, and it was named “America’s Most Innovative Company” by Fortune for six consecutive years: 1996–2001.

Blockbuster’s Role

One of the many unwitting players in the Enron scandal was Blockbuster, the former juggernaut video rental chain. In July 2000, Enron Broadband Services and Blockbuster entered a partnership to enter the burgeoning video on demand (VOD) market. The VOD market was a sensible pick, but Enron started logging expected earnings based on the expected growth of the VOD market, which vastly inflated the numbers.

By mid-2000, EOL was executing nearly $350 billion in trades. When the dot-com bubble began to burst, Enron decided to build high-speed broadband telecom networks. Hundreds of millions of dollars were spent on this project, but the company ended up realizing almost no return.

When the recession hit in 2000, Enron had significant exposure to the most volatile parts of the market. As a result, many trusting investors and creditors found themselves on the losing end of a vanishing market capitalization.

The Wall Street Darling Crumbles

By the fall of 2000, Enron was starting to crumble under its own weight. Skilling hid the financial losses of the trading business and other operations of the company using MTM accounting. This technique measures the value of a security based on its current market value instead of its book value. This can work well when trading securities but can be disastrous for actual businesses.

In Enron’s case, the company would build an asset, such as a power plant, and immediately claim the projected profit on its books, even though the company had not made one dime from the asset. If the revenue from the power plant was less than the projected amount, instead of taking the loss, the company would then transfer the asset to an off-the-books corporation, where the loss would go unreported. This type of accounting enabled Enron to write off unprofitable activities without hurting its bottom line.

The MTM practice led to schemes designed to hide the losses and make the company appear more profitable than it really was. To cope with the mounting liabilities, Andrew Fastow, a rising star who was promoted to chief financial officer (CFO) in 1998, developed a deliberate plan to show that the company was in sound financial shape despite the fact that many of its subsidiaries were losing money.

How Did Enron Hide Its Debt?

Fastow and others at Enron orchestrated a scheme to use off-balance-sheet special purpose vehicles (SPVs), also known as special purposes entities (SPEs), to hide Enron’s mountains of debt and toxic assets from investors and creditors. The primary aim of these SPVs was to hide accounting realities rather than operating results.

The standard Enron-to-SPV transaction would be the following: Enron would transfer some of its rapidly rising stock to the SPV in exchange for cash or a note. The SPV would subsequently use the stock to hedge an asset listed on Enron’s balance sheet. In turn, Enron would guarantee the SPV’s value to reduce apparent counterparty risk.

Although their aim was to hide accounting realities, the SPVs were not illegal. But they were different from standard debt securitization in several significant—and potentially disastrous—ways. One major difference was that the SPVs were capitalized entirely with Enron stock. This directly compromised the ability of the SPVs to hedge if Enron’s share prices fell. Just as dangerous was the second significant difference: Enron’s failure to disclose conflicts of interest. While Enron disclosed the SPVs’ existence to the investing public—although it’s quite likely that few people understood them—it failed to adequately disclose the non-arm’s-length deals between the company and the SPVs.

Enron’s management believed that its stock price would continue to appreciate—a belief similar to that embodied by Long-Term Capital Management, a large hedge fund, before its collapse in 1998. Eventually, Enron’s stock declined. The values of the SPVs also fell, forcing Enron’s guarantees to take effect. 

Jim Chanos’ Short Trade on Enron

Jim Chanos of Kynikos Associates is a well-known short seller. At a SEC-led roundtable on hedge funds in May 2003, Chanos said that his interest in Enron and other energy trading companies was “piqued” in October 2000 after a Wall Street Journal article pointed out that many of these firms employed the “gain-on-sale” accounting method for their long-term energy trades. According to Chanos, his experience with companies that had used this accounting method was that management had too great a temptation to be overly aggressive about making assumptions regarding the future, and “earnings” could effectively be created out of thin air if management was willing to push the envelope by using highly favorable assumptions.

Chanos also noted that Enron’s cost of capital was closer to 9% and likely above the 7% return on capital—a widely used profitability metric—that it claimed to have, which meant that it was not really earning money despite reporting profits to its shareholders. Chanos said that this mismatch of Enron’s cost of capital and its return on investment became the cornerstone of his bearish view on Enron, and his firm began shorting Enron’s common stock for its clients in November 2000. This short trade netted Chanos and his Kynikos firm hundreds of millions in gains when Enron went under.

Arthur Andersen and Enron

In addition to Fastow, a major player in the Enron scandal was Enron’s accounting firm, Arthur Andersen LLP, and partner David B. Duncan, who oversaw Enron’s accounts. As one of the five largest accounting firms in the United States at the time, Andersen had a reputation for high standards and quality risk management.

However, despite Enron’s poor accounting practices, Arthur Andersen offered its stamp of approval, signing off on the corporate reports for years. By April 2001, many analysts started to question Enron’s earnings and transparency.

The Shock Felt Around Wall Street

By the summer of 2001, Enron was in freefall. Lay had retired in February, turning over the CEO position to Skilling. In August 2001, Skilling resigned as CEO, citing personal reasons. Around the same time, analysts began to downgrade their rating for Enron’s stock, and the stock descended to a 52-week low of $39.95. By Oct. 16, the company reported its first quarterly loss and closed its Raptor I SPV. This action caught the attention of the SEC.

A few days later, Enron changed pension plan administrators, essentially forbidding employees from selling their shares for at least 30 days. Shortly after, the SEC announced that it was investigating Enron and the SPVs created by Fastow. Fastow was fired from the company that day. Also, the company restated earnings going back to 1997. Enron had losses of $591 million and $690 million in debt by the end of 2000. The final blow was dealt when Dynegy, a company that had previously announced it would merge with Enron, backed out of the deal on Nov. 28. By Dec. 2, 2001, Enron had filed for bankruptcy.

Bankruptcy

Once Enron’s Plan of Reorganization was approved by the U.S. Bankruptcy Court, the new board of directors changed Enron’s name to Enron Creditors Recovery Corp. (ECRC). The company’s new sole mission was “to reorganize and liquidate certain of the operations and assets of the ‘pre-bankruptcy’ Enron for the benefit of creditors.” The company paid its creditors more than $21.7 billion from 2004 to 2011. Its last payout was in May 2011.

Criminal Charges

Arthur Andersen was one of the first casualties of Enron’s notorious demise. In June 2002, the firm was found guilty of obstructing justice for shredding Enron’s financial documents to conceal them from the SEC. The conviction was overturned later on appeal; however, the firm was deeply disgraced by the scandal and dwindled into a holding company. A group of former partners bought the name in 2014, creating a firm named Andersen Global.

Several of Enron’s executives were charged with conspiracy, insider trading, and securities fraud. Lay, Enron’s founder, and former CEO was convicted on six counts of fraud and conspiracy and four counts of bank fraud. Prior to sentencing, he died of a heart attack in Colorado.

Fastow, Enron’s former star CFO, pleaded guilty to two counts of wire fraud and securities fraud for facilitating Enron’s corrupt business practices. He ultimately cut a deal for cooperating with federal authorities and served more than five years in prison. He was released from prison in 2011.

Skilling, Enron’s former CEO, ultimately received the harshest sentence of anyone involved in the scandal. In 2006, Skilling was convicted of conspiracy, fraud, and insider trading. Skilling originally received a 17½-year sentence, but in 2013, it was reduced by 14 years. As a part of the new deal, Skilling was required to give $42 million to the victims of the Enron fraud and to cease challenging his conviction. Skilling was originally scheduled for release on Feb. 21, 2028, but was instead released early on Feb. 22, 2019.

New Regulations After Scandal

Enron’s collapse and the financial havoc that it wreaked on its shareholders and employees led to new regulations and legislation to promote the accuracy of financial reporting for publicly held companies. In July 2002, then-President George W. Bush signed into law the Sarbanes–Oxley Act. The act heightened the consequences for destroying, altering, or fabricating financial statements and for trying to defraud shareholders.

The Enron scandal resulted in other new compliance measures. Additionally, the Financial Accounting Standards Board (FASB) substantially raised its levels of ethical conduct. Moreover, company boards of directors became more independent, monitoring the audit companies and quickly replacing poor managers. These new measures are important mechanisms to spot and close loopholes that companies have used to avoid accountability.

The Bottom Line

At the time, Enron’s collapse was the biggest corporate bankruptcy to ever hit the financial world (since then, it has been surpassed by the bankruptcies of other former giants, including Lehman Brothers, Washington Mutual, WorldCom, and General Motors). The Enron scandal drew attention to accounting and corporate fraud as its shareholders lost $74 billion in the four years leading up to its bankruptcy, and its employees lost billions in pension benefits.

Increased regulation and oversight have been enacted to help prevent corporate scandals of Enron’s magnitude. However, some companies are still reeling from the damage caused by Enron. Most recently, in March 2017, a judge granted a Toronto-based investment firm the right to sue Skilling (the former Enron CEO), Credit Suisse Group AG, Deutsche Bank AG, and Bank of America’s Merrill Lynch unit over losses incurred by purchasing Enron shares.