The Fall of Enron

If you said to me, “Jon, what’s the biggest ethical crisis in the world of money and finance that you can think of?” I’d probably ignore your question. Realistically, though, one scandal comes to the forefront of my mind and probably would do the same for many of your parents – Enron. However, like me, you probably didn’t really know many details about the Enron scandal until this blog post.

Enron Logo | Courtesy of LogoMaker

In 1985, Enron formed from acquisitions within the natural gas industry. Initially focusing on energy, Enron quickly expanded into a variety of other fields, including internet, weather insurance, and risk management, quickly earning them the distinction of “America’s Most Innovative Company” from Forbes magazine every year from 1996 to 2001.

Many had huge faith in Enron’s potential and saw themselves swimming in piles of money by investing in the up and coming company. In 1992, unbeknownst to most, Jeff Skilling, former CEO of Enron, received permission from regulators to use an accounting method known as “mark to market”. This method of recording assets can be fairly confusing, but the Journal of Accountancy describes it as a practice in which “companies [that] have outstanding energy-related or other derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter…must adjust them to fair market value, booking unrealized gains or losses”. Simply put, companies record assets and liabilities that haven’t really been capitalized yet on their current balance sheet. For Enron, many of the long-term contracts they held were difficult to value; therefore, “it is possible [read: true] that valuation estimates might have considerably overstated earnings” for Enron balance sheets.

Courtesy of Aftab Khan

Clearly, this practice dupes investors into believing that Enron is doing much better than it actually is. Projecting very optimistic returns overstated Enron’s actual value, keeping its stock price high without actually generating much taxable revenue. Using this strange accounting system, Enron opened the door for Andrew Fastow’s devious plan to use special purpose entities.

Andrew Fastow | Courtesy of NBC

Fastow, CFO of Enron as of 1998, developed a unique plan to hide the losses that Enron was recording in various other business entities to keep its own books clean and solvent. This not only allowed Enron to maintain a high stock price but also preserved a high credit rating for a firm that clearly did not deserve any sort of credit considering the questionable nature of its practices. Once Enron crashed, Fastow was charged with nearly 80 counts of fraud, the majority of which were connected to this practice of disguising Enron’s financial state through other minor companies that earned him tens of millions and kept Enron in the clear.

In early 2000, Enron first began to show signs of cracking. The telecom industry hit a rough patch, and Enron suffered heavily as people began trying to figure out how Enron really worked. Amid this turbulence, Jeff Skilling resigned as CEO, and Chairman Ken Lay stepped (back) in as CEO. Following this leadership change, Sherron Watkins, a VP at Enron, contacted Lay and explained that Skilling probably left because of accounting issues.

Kenneth Lay | Courtesy of Biography.com

 Enron continued to find itself in more and more hot water. As its stock fell, Enron began to become responsible for the struggles of Fastow’s branch companies, only hastening Enron’s collapse. In October 2001, Enron stunned the country, announcing that it would post quarterly losses of $638 million. Continuing to spiral out of control, Enron stock fell from an all-time high of $90.75 in August of 2000 to $0.40 by December of 2001. Finally, in December, Enron declared bankruptcy, closing the book on a disastrous fall from glory.

Courtesy of Startup Juncture

Enron’s collapse left many individuals in a poor state of affairs. Enron’s chief accounting firm and auditor, Andersen, was convicted of obstruction of justice for shredding Enron files immediately following the bankruptcy declaration. Andrew Fastow, former CFO and mastermind of the debt-hiding system, accepted a plea bargain in early 2004 in which he testified against other former Enron executives in exchange for a punishment reduction to ten years of jail time and nearly $30 million in damages.

Many Enron executives pleaded the Fifth Amendment during the investigation, but Skilling refrained. Instead, Skilling insisted that he had absolutely no knowledge of the scandal, a difficult notion to swallow from the former CEO. He was sentenced to 24 years of jail time. Lay was one of the many to remain silent and was found guilty on ten counts of conspiracy and fraud. Before he could be sentenced, Lay suffered a fatal heart attack in July of 2006.

In hindsight, the regulation that allowed Enron to engage in such risky financial manipulation was clearly insufficient. Following the fallout, Congress passed the Sarbanes-Oxley Act of 2002 to heighten regulation and stiffen the penalties for financial manipulation. The Financial Accounting Standards Board also enhanced its level of involvement in an attempt to prevent such conduct again. Enron’s fall, a devastating collapse that impacted thousands of people, was a solemn reminder of the power that profit-hungry executives wield. It reminds us that we must be careful and scrutinous of those who have such awesome power; it reminds us of the importance of the ethics of money.