Enron Banktruptcy

INTRODUCTION On December 2, 2001 The Enron Corporation filed for bankruptcy. Till that point Enron was the largest energy supplying company of the world. The Enron Corporation became one of the largest bankruptcies in U.S. history. The company’s collapse resulted from the disclosure that it had reported false profits, using creative 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. But how did Enron succeed to hide its losses for so long? In today’s modern economy, how is it possible that they could cover up the fraud for nearly five years? Has anyone been held personally responsible for this and what are the consequences for American economy, personnel and customers? What is understood by Enron’s “creative accounting? These answers, all analysts, judges and every economic interested citizen would like to know. The failure of America’s fastest growing company brought along many investigations and a brand new legislation. Did this bankruptcy came by blue sky or were there any warnings? 1. ENRONS BRIEF HISTORY Enron was formed in 1985 by the merger of InterNorth, a gas pipeline company based in Omaha, Nebraska, and HoustonNaturalGas, a Texas-based gas pipeline-company. The merger created the largest natural gas pipeline system in the United States. All 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. Ken Lay, former Chief Executive Officer of HoustonNaturalGas, was named Chief Executive Officer and Chairman of Enron. 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 (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). (Lambert, 2001)
2. FAST GROWING MARKET By the late 1990s Enron controlled some 25 percent of all electricity and natural gas contracts traded worldwide and was considered the best in the business. In 1999 Enron formed Enron Online, which quickly became the largest e-business site in the world. Enron changed the landscape for energy trading and it generated funds by entering into extremely volatile, risky, and expensive hedging transactions. These trading operations relied mainly on very complicated financial transactions. 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
But what was Enron, really? In essence, it was an insurance company. Some would say a hedge fund. It wasn't just selling gas and megawatts, coal and bandwidth. It was selling protection, stability and peace-of-mind. For a price, with the click of a mouse, you could lock-in reportable up-front profits, or limit potential losses, on an innumerable of commodities. And, at every turn, Enron would book a profit. 3. ENRONS DEMISE Enron's decline began when investors became aware of "off balance sheet" partnerships that hid billions of dollars of liabilities. (figure: www.orlandosentinel.com) Many entities, like Enron, used special purpose entities (SPE) because as long as at least 3% of capital comes
from outsiders, an SPE can be left off the consolidated financial statements of the parent company. Enron apparently cooked the books as this would make their shares more viable, while creating little or no real shareholder and creditor value, as was revealed when the questionable accounting and financial reporting decisions were publicly disclosed. The year 2001 brought sobering news. In March a planned deal with Blockbuster Inc., the motion-picture video rental company, to provide movies over the Internet was cancelled. In April Enron revealed that it was owed more than $500 million by bankrupt California energy companies. Insiders admitted that they were extremely nervous that Enron would implode in a series of accounting scandals and informed Chairman and Chief Executive Officer Kenneth Lay. In a few months, the corporate officers who created one of the world's largest companies panicked as they frantically and unsuccessfully tried to save it. 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. After the company’s stock collapsed, Enron’s demise was considered as the biggest crisis investors have had since 1929 following Alan Reinstein. (Reinstein, A. 2002) 4. ENRON INVESTIGATIONS The failure of one of the nation’s largest and best-run companies brought intense media and government scrutiny. A brief period after the failure the justice department decided to take on a major investigation against the Enron company. The first major investigation concerned the use of “special purpose entities” (SPE). The Enron’s executives apparently used about 500 SPE’s to deceive shareholders and to enrich themselves. Other investigations concerned the political support in exchange for fat fees, Enron’s creative accounting, insider trading and the Andersen audit committee who destroyed Enron documents.
4.1 Creative Accounting How could 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 cleverest investors around. To give the appearance of rapid earnings growth and to avoid reporting its mounting losses, 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).” Enron used about 500 such SPEs and thousands of other questionable partnerships in order to structure transactions to achieve off-balance sheet treatment of assets and liabilities. Enron executives often held large personal interests in these partnerships and made massive personal gains in such transactions. 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. 4.2 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 nose-dived, 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. 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. (Nelson, 2002) 4.3 Arthur Andersen Where were Enron’s audit committee and its external auditing firm, Arthur Andersen? 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 manoeuvres. 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. (Campbell ,W. 2003) 4.4 Political Scandal? But if the audit committee doesn’t control Enron, isn’t it the government’s task to interfere in this giant fraud? Well Enron and Andersen collectively spent $11 million on Congressional members' campaigns over the last 10 years. During the 2000 campaign, Enron contributed over $1.1 million to Bush's campaign. Enron was able to gain political favours by supplying campaign money to politicians from both major parties, thereby blinding these otherwise public-spirited people from performing their duties to the people. Enron has given vast sums of cash to both Republicans and Democrats. While Democrats are presently attempting to link Enron and its chairman, Kenneth Lay, to President George Bush and Vice President Richard Cheney, they conveniently seem to have forgotten that Enron in 1997 contributed $100,000 to the Democratic Party immediately after President Bill Clinton directly intervened to help Enron gain a $3-billion project in India. The problem here is that the energy business, including oil and electricity, has been thoroughly politicised for about a century. Producers of electricity have been and continue to be heavily regulated, both by state and federal agencies. Oil is such another thoroughly politicised commodity. Given this set of circumstances, any firm that has anything to do with oil, natural gas, or electricity is going to have to pay tribute to our political masters. The vast amount of political contributions is nothing more than protection money that companies must give to politicians in order to be permitted to stay in business. (Hedges, M. 2002) When the federal regulators stepped in on June 19, 2001, Enron lost their ability to manipulate the power supply and charge excessive rates. Because speculation does not include significant asset ownership, Enron's unregulated energy auction scheme quickly turned into massive debt for the company. 5. AFTER ENRON 5.1 Consequences for the American economy 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, and they silently admit that they, too, engaged in creative accounting. A couple of very large firms, Worldcom.Inc and Global Crossing, went bankrupt in the wake of accounting scandals. (Cramton, 2002)
5.2 Enron’s Legacy Enron’s legacy may be widespread reform of corporate behaviour. 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 “wilfully 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. CONCLUDING ANALYTICAL COMMENTS The Enron scandal symbolized in many ways the excessives of corporations during the long economic boom of the 1990s in the United States. Enron’s managers, whose activities brought the company on the verge of disaster, 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 large proportion of retirement savings invested in Enron stock. The Enron scandal played a major role in shaking the investor’s confidence in American economy because the firm succeeded in hiding its losses for nearly five years. The scandal resulted in new legislation that drastically reformed accounting practices and strengthened the ability of the Securities and Exchange Commission (SEC) to investigate accounting fraud. In addition to the failure of outside auditors and internal corporate oversight, many experts believe that the federal government also carries some responsibility for the situation. Politicians in both 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. But are the measures enough to avoid another Enron case? We can never exclude that such fraud will happen again but the measures that have been taken are certainly a step in the right direction. We should almost guarantee to customers and investors that extern and internal control are excluded from fraud, so they should be adequate enough to warn the public if problems arise. As long as inside fraud of auditor committees and politicians occur again, and they will, we can’t assure to avoid another Enron case. The Enron scandal reminds the Americans that a capitalist needs full and fair disclosure. Many observers blamed the Enron executives who only enriched themselves. But the reason it became a national scandal was that those who could have helped check the executives’ conduct failed to do so.