The Enron scandal in 2001 became the largest corporate bankruptcy in U.S. history. It featured a loophole in the accounting principles that allowed corporations to maintain entities off their consolidated books as long as the parent company owned less than 50% of the entity and the entity was adequately capitalized. A clever but crooked financial officer for Enron exploited this loophole moving tens of millions of dollars of debt off of Enron’s books. Here’s how the scandal unfolded.
What Was Enron?: Enron was an energy, commodities, and services corporation formed in 1985 by the merger of two small regional energy companies—one in Omaha, Nebraska and the other in Houston, Texas. Their products were electricity, natural gas, and communications, along with pulp and paper. Together they formed one of the largest pipeline networks of the time with one faction running north/south from Minnesota through Iowa, and the other running east/west from Florida to California. Their vision in 1986 was to become the premier natural gas pipeline company in the United States. At the time of their bankruptcy in December, 2001, they employed nearly 21,000 people and purported to have revenues for the year of $101 billion.
The Enron Collapse: The early years of the merger did not prove to be lucrative, however, and the management began to look for other ways to generate income. They then decided to build up their business by trading energy commodities, including water and fiber optic bandwidth, in markets that had recently been deregulated. They created the “Gas Bank” that enabled customers to hedge the price of natural gas while buying from Enron. Later they began trading futures and options including swaps on the New York Mercantile Exchange, becoming more of a company of risk takers in the process.
Accounting Fraud: In 1990, Andrew Fastow was hired as Chief Financial Officer, and he set up a web of companies on paper known as special purpose entities that did business only with Enron. Fastow was able to conceal Enron’s massive debt onto the books of these special purpose entities, turning them in structured investment vehicles in the process. A structured investment vehicle is a special purpose entity that’s used to borrow money on the short-term and invest it long term. Short-term borrowing is typically commercial paper, and long-term investing is typically bonds or asset-backed securities such as mortgage CDO’s, but primarily these SIV’s were meant to hide Enron’s staggering debt. By recording transactions as “marked to market” they included gains which were not yet realized. By manipulating its stock price, it stayed as high as $90 per share during the crisis, enabling executives and insiders who knew about the impending disaster to bail out while ordinary employees were saving shares into their 401K savings plans.
Enron’s Downfall: Fastow was making millions manipulating the money hidden in the shadow ownership system of SIV’S that he created. In October, 2001, he revealed that the SIV scheme had made the company $45 million, but that claim later went into the hundreds of millions. He further claimed that he only spent a few hours a week with the SIV’s, but the remainder of the accounting processes in the parent company went neglected. With an audit coming up, Fastow was placed on leave and Jeff McMahon took over Enron’s confusing accountability. With the help of a financial “SWAT” team, McMahon determined that Enron was basically illiquid, as Fastow had lost control over cash management. Many of Enron’s assets were either inflated in value or fraudulent altogether. About 21,000 employees were laid off only to find out that in many cases their 401K plans were wiped out by the decline of Enron’s stock price.
The Independent Auditors Went Along with All of it: Arthur Andersen, one of the premier CPA firms in the entire profession, audited Enron’s books and records as required by law for publicly held corporations. As a result, the accountants that worked on the audit were blatantly aware of what was transpiring. But Enron paid Arthur Andersen a $25 million audit fee that was eclipsed by an additional $100 million in consulting fees! Andersen even helped with the design of the system, and then went in and audited what they knew would be a whitewash of the company’s books and financial reports. Under accounting rules, the special purpose entities were required to be independent of Enron’s management, and adequately capitalized. In reality the SPE’s held only Enron’s debt with whatever capital was included being siphoned off in the scam. Further, Enron could not guarantee their losses. Even Andersen’s partners were made aware of the extent of the scandal and their firm’s involvement, but ignored the warnings from their staff and agreed to sign off on their financial statements keeping Enron in good standing with the Security and Exchange Commission and bolstering Enron’s stock price.
The Ensuing Crash: With the disclosure by McMahon’s internal audits revealing that Enron was flat broke, the company declared bankruptcy in December, 2001. This occurred after Enron had reached as high as seventh in Fortune Magazine’s top 500 U.S. companies. Owing to the catastrophic fall in price of the stock (from $90.75 in August, 2000, to $0.26 in November, 2001), the Securities and Exchange Commission investigated the scandal. But Andersen’s employees went to great lengths to destroy evidence by deleting emails and shredding documents based on internal documentation orders that were designed to protect the firm. Andersen was charged and convicted with obstruction of justice, but the conviction was later overturned by the U.S. Supreme Court on a technicality. But the damage had been done. In an industry where ethics and integrity are of the utmost importance, Andersen failed. A large number of quality clients immediately withdrew from Andersen. Many of the partners who were not connected with Enron took their clients, out of the firm and joined other firms. With many clients leaving, Andersen soon closed its doors laying off about 85,000 employees. Its demise shocked the entire accounting profession.
Other ramifications: The fallout from Enron’s scandal and bankruptcy led to a number of indictments besides Arthur Andersen CPA’s. Some of them are as follows:
Enron CEO Kenneth Lay was convicted on ten counts of fraud, conspiracy, and insider trading, as he attempted to dispose of 60 million shares of his stock before the impending crash. He died two months afterward and his conviction was vacated.
Andrew Fastow pleaded guilty to two counts of wire and securities fraud and was sentenced to 10 years on the promise that he would help convict other defendants in the case.
Jeffrey Skilling, COO, refused to acknowledge that he knew about any part of the scandal although he unloaded about $60 million worth of Enron stock shortly after resigning. He was convicted on 19 counts and was sentenced to 24 years in prison. It should be noted that while still a consultant for McKinsey & Company, Skilling brought the culture of gambling and risk taking to Enron with the Gas Bank in 1989. He was then hired in 1991as the head of Gas Bank, and chief risk taker of the organization.
Conclusions: The Enron scandal existed in its size and magnitude only because of the co-operation of Enron’s auditors, Arthur Andersen & Company. The fraud existed because the financial reporting appeared to be legitimate owing to the independent auditor’s approval. Since this fraud was supported by one of the top leading CPA firms in the country, it shook the core of the profession and certainly made many investors wonder what other auditing firms may have been bought to look the other way. Consequently, The Financial Accounting Standards Board, the governing body that determines what generally accepted accounting principles are, issued a pronouncement requiring that all structured investment vehicles that were connected to or supported by a publicly held corporation must be included into their consolidated financial reports regardless of what percentage of ownership.
Sources: Enron Files for Bankruptcy, This Day in History, by History.com Editors.
Wikipedia, Structured Investment Vehicles.
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