The Enron scandal and corporate accounting fraud

Enron Scandal: Who was Responsible and Why?

Background of Enron Scandal and Timeline of Events

Key Players in Enron Scandal

The Enron Scandal was the biggest accounting fraud in U.S., indeed worldwide, business history. The following paper gives a brief history of the events leading up to the scandal, a timeline for the events surrounding the uncovering of the scandal and the events following the public knowledge of the scandal. Key players in the run-up to the scandal are discussed, as are the people involved in the subsequent investigations.

Background of Enron Scandal and Timeline for Events

The collapse of energy giant Enron is the largest bankruptcy and one of the most shocking failures in United States corporate history. In a little over 15 years, Enron grew into one of the U.S.'s largest companies. It embraced new technologies, established new methods of trading in energy and seemed to be a shining example of successful corporate America. The company's success, however, was based on artificially inflated profits, dubious accounting practices, and - some say - fraud.

In the 1980s, energy corporations lobbied Washington to deregulate the business. Companies including Enron argued that the extra competition would benefit both companies and consumers. Washington began to lift controls on who could produce energy and how it was sold. New suppliers came to the market and competition increased, but the price of energy became more volatile in the free market. Enron saw its chance to make money out of these fluctuations. It decided to act as middle-man and guarantee stable prices - taking its own cut along the way. Kenneth Lay (Chief Executive, Chairman and Board Member of Enron) had been anxious to expand the business right from the word go. Jeff Skilling (Chief Executive, President and Chief Operating Officer of Enron), an ambitious thinker from the world famous consultancy firm McKinsey, offered a way to do this.

Skilling believed that Enron could profit from trading futures in gas contracts between suppliers and consumers - effectively betting against future movements in the price of gas-generated energy. Buyers and sellers use futures markets to get what they hope will be a better deal on commodity prices than they would do on the open market. Enron offered to do the same with gas, by buying and selling tomorrow's gas at a fixed price today. In the deregulated energy world, it appeared to make sense to many suppliers and industry consumers who took up the offer. The new Enron was emerging. In a few short years, Enron became a massive player in the U.S. energy market, at its height controlling a quarter of all gas business. Buoyed by the success, the company went on to create markets in myriad energy-related products.

Enron began to offer companies the chance to hedge against the risk of adverse price movements in a range of commodities including steel and coal. By the end of the decade, it had expanded its trading arm to include hedging against external factors such as weather risk. Enron was not the only company in the game, but through its Enron online trading arm, it was becoming the biggest on what was dubbed Energy Alley - 90% of its income came from trades.

Jeff Skilling wanted to rid Enron of its last physical assets, but the company was also expanding internationally, moving into water in the UK and power generation in India. One question that was already being asked before Enron crashed was this: how much influence did Enron have on Capitol Hill? Enron certainly wasn't the only company lobbying for energy deregulation, but deregulation helped Enron establish the trading markets that became its core business.

Directors built relationships with both Democrats and Republicans. Kenneth Lay himself had strong personal ties to two Republican presidents, George Bush Sr. And his son, George W. Bush. As Enron expanded, there was little scrutiny of how it was managing the expansion, and when it began to unravel, the questions began to pour in. Enron began the year 2000 with a plan to move into broadband internet networks and trade bandwidth capacity as the dot.com economy prospered. Enron's dynamic ideas, coupled with its stable old-economy energy background, appealed to investors and the share price soared.

It was one of the first amongst energy companies to begin trading through the internet, offering a free service that attracted a vast amount of custom. But while Enron boasted about the value of products that it bought and sold online - a mind-boggling $880bn (£618bn) in just two years - the company remained silent about whether these trading operations were actually making any money.

At about this time, it is believed that Enron began to use sophisticated accounting techniques to keep its share price high, raise investment against it own assets and stock and maintain the impression of a highly successful company. Enron could also legally remove losses from its books if it passed these "assets" to an independent partnership. Equally, investment money flowing into Enron from new partnerships ended up on the books as profits, even though it was linked to specific ventures that were not yet up and running.

One of these partnership deals was to distribute Blockbuster videos by broadband connections. The plan fell through, but Enron had already posted some $110m venture capital cash as profit. By the summer, Enron's shares had hit an all time high of more than $90, but there was also controversy. California was suffering an energy crisis, blamed by many on its poor handling of deregulation. Some claimed Enron had profiteered by buying futures in electricity supplies and passing them on at higher costs. Enron dismissed the allegation saying it was merely the market-maker. Enron's 2000 annual report reported global revenues of $100bn, with income that had risen by 40% in three years.

In reality, real revenue would have been far lower had it not been for the special partnerships established by chief finance officer Andrew Fastow.

Enron's growth was increasingly dependent on these accounting tools. Enron made investments and then shifted the debt off of its books to theoretically independent partnerships, in return for potential income that provided a buffer against future losses. Meanwhile, Enron kept up its political donations. Chief among the individual donors was Kenneth Lay himself. Enron and Kenneth Lay each donated $100,000 to incoming President Bush's inaugural committee fund, early in 2001. The incoming president invited Ken Lay to become and advisor to his transition team.

A prime concern for Enron was the new president's planned energy policy review, headed by Vice-President Dick Cheney. Mr. Lay and other Enron directors met Mr. Cheney and others three times in the first half of the year, the last meeting a month before he published his conclusions on 17 May 2001.

The review, as predicted, was favourable to the energy industry. It advocated more power stations, more exploration and a national grid. While it did not meet all of Enron's wishes, it nevertheless was good news. On 14 August 2001, seemingly from nowhere, Jeff Skilling resigned as chief executive, citing personal reasons. Kenneth Lay became chief executive once again. The development was a shock to investors who suddenly began to fear that all was not well in Houston.

Investors sold millions of shares, knocking some $4 off the price by the end of the week. As the price dropped below $40, Mr. Lay insisted that there were "no issues." There was, however, a very large issue - perhaps one that the board was not fully aware of. In May of that year, Enron executive Clifford Baxter left the company, apparently in uncontroversial circumstances. But there were rumours among executives that Mr. Baxter - soon to become a tragic figure in the affair when he took his own life - had clashed with Jeff Skilling over the propriety of some of the partnership transactions. When Mr. Skilling resigned, one executive who knew of Mr. Baxter's concerns decided to act, and warned Mr. Lay that Enron was on the verge of "imploding."

Meanwhile, on 12th October, the depth of Enron's problems were beginning to dawn on Andersen. As Enron had hedged against its own stock, it could never recover its losses while its share price was falling. Andersen told Enron that it had no other choice but to change the way it was accounting for its special partnerships. On 12 October, an Andersen lawyer contacted a senior partner in Houston to remind him that company policy was not to retain documents that were no longer needed. At some point after this, staff in Andersen's Houston office began shredding documents relating to Enron. Around the same time, Enron's internal legal examination of Sherron Watkin's concerns concluded that the partnerships in question, Raptor and Condor, had been approved by Andersen.

From the 1st to the 9th November, despite the air of impending doom, Kenneth Lay found two banks willing to extend credit, but the worst of revelations was still to come. On 8 November, the company took the highly unusual move of restating its profits for the past four years. It effectively admitted that it had inflated its profits by concealing debts in the complicated partnership arrangements. The following day, the humiliation of Enron appeared complete as it entered negotiations to be taken over by its much smaller rival, Dynegy.

By 2nd December, and no longer able to cope with its debt, Enron filed for bankruptcy protection in a New York court, simultaneously launching a legal action against Dynegy for pulling out of the merger. In three months, Enron had gone from being a company claiming assets worth almost £62bn to bankruptcy. Its share price collapsed from about $95 to below $1. "Uncertainty has severely impacted the market's confidence in Enron and its trading operations," Kenneth Lay commented as he saw his company implode.

From 9th - 10th January, while America reeled from the bankruptcy and Enron employees, past and present, worked out what they had left, the Justice Dept announced a criminal investigation. Attorney General John Ashcroft, who had received campaign funds from the company in 2000, excluded himself from the investigation, along with the 100 federal investigators in Houston. The following day, Andersen, its role increasingly in the spotlight, admitted that employees had disposed of Enron documents.

The White House also confirmed speculation that Kenneth Lay had appealed to members of the administration for help. The shockwaves of a corporate crash are always keenly felt - but few failures have led to the kind of investigations Enron and its managers now face. February opened with the publication of the company's own internal investigation into the crash. William Powers, the academic who chaired the report, didn't pull any punches when he pinned the blame firmly on executives who had personally benefited from the partnerships to the tune of millions of dollars (www.bbc.co.uk):"There was a fundamental default of leadership and management," he said. "We found a systematic and pervasive attempt by Enron's management to misrepresent the company's financial condition."

Congress continued hearings, which began in December, as America and investors around the world demanded answers. Four of Enron's most senior executives pleaded Fifth Amendment protection against self-incrimination and refused to testify: Andrew Fastow, chief risk officer Richard Buy, finance executive Michael Kopper and Kenneth Lay himself.

Jeff Skilling did testify, but insisted that he knew nothing of the complex web of intra-company deals that are almost impossible for ordinary investors to unravel. On Valentine's Day, the woman who originally raised fears of an implosion, took the stand. Sherron Watkins said that Ken Lay and the board had been "duped" by Mr. Fastow and Mr. Skilling. Mr. Lay had never really understood the gravity of the situation, she said.

Events have continued from here on, with revelations that Enron also avoided paying tax throughout their time in business, and that top executives were paid huge salaries, even whilst lower-level employees were being made redundant, amongst others. But, who, throughout this whole sorry history of Enron, were the key players?

2. Key Players in the Enron Scandal

As we have seen, Enron was a high-flying energy company that sought to transform itself into the world's biggest energy trader. Most Enron executives appear to have condoned these practices; indeed, many executives benefited from the company's high share price by cashing in their stock options. Employees who had, however, put all their pension money in Enron shares lost everything when the firm went bankrupt in December. Who were these Enron executives?

Ken Lay was the Enron chief executive, chairman and board member of Enron, before resigning at the end of January 2002. After the company collapsed, he became the focus of the anger of disaffected employees and pension and stock holders who had lost billions of dollars. He had, in happier days, been credited with building Enron's staggering success. He took up the reins at Enron in 1986 after it was formed from the merger of two pipeline firms in Texas and Nebraska. Over the next decade Enron grew into the world's largest energy trading firm. But, under his leadership, the company managed to conceal its massive debts through questionable accounting. He relinquished his chief executive role in December 2000 and was replaced by Jeffrey Skilling. In August 2001, however, he resumed day-to-day management of the company after Mr. Skilling resigned. Mr. Lay was a political ally of the Republicans, particularly President George Bush, who once nicknamed him "Kenny boy." Enron contributed millions of dollars to various political campaigns and Mr. Lay, along with other Enron executives, advised on U.S. energy policies. He was also a prominent figure in Houston arts and charity circles.

Jeff Skilling is the Former chief executive, president and chief operating officer of Enron. Mr. Skilling left his post as Enron's chief executive in August 2001, saying he wanted to spend more time with his children and on his charity work. He departed without a pay-off and was reported to have sold millions of dollars' worth of Enron stock after leaving. Testifying before Congress, he vehemently denied any knowledge of the complex web of financial arrangements that became Enron's downfall. Prior to becoming chief executive in February 2001, he was president and chief operating officer of the firm: he was also seen as a key architect of the company's gas-trading strategy. At Enron, he gained a reputation for being tough, confident and full of swagger, and also championed Enron's online trading operation, although he was initially slow to lend his support. When asked whether he was concerned about undercutting the company's traditional phone trading, he said: "If you can cannibalise your own sales, you'd better do it because otherwise someone's going to do it to you. This organisation believes in creative destruction."

And who were the Andersen employees who were involved in this scandal? Andersen's role in the Enron affair has brought the once prestigious accounting firm to its knees. Its job was to check that the company's accounts were a fair reflection of what was really going on: as such, they were the first line of defence in the case of any fraud or deception.

When the scandal broke, as the government began to investigate the company's affairs, Andersen's chief auditor for Enron, David Duncan, ordered the shredding of thousands of documents that might prove compromising. Andersen dismissed Mr. Duncan, but insisted that the firm did not act improperly and could not have detected the fraud. In June 2002, Andersen's U.S. division was found guilty by federal prosecutors of obstructing the course of justice. Pre-empting its official punishment, Andersen voluntarily agreed to stop auditing public companies in the U.S. Many important clients had already deserted the sinking ships, and its international businesses has been divided up between its rivals. Earlier attempts to save itself through a merger ended in failure. Following the conviction, multi-million dollar lawsuits brought by Enron investors and shareholders demanding compensation are likely to follow, and could bankrupt the firm.

And who were the people from the Bush administration that were involved in the Enron scandal? There is no suggestion that the myriad connections between the administration of President Bush and Enron were illegal. The corporation had close relations with many Democrats and Republicans in Congress. Links exist between Enron and the current administration at all levels - personal, social, financial, professional and political. Political rivals of President Bush have said, however, that the sheer volume of links between the administration and Enron may build up a highly damaging perception of guilt by association. According to reports, 35 administration officials have held Enron stock - some had six figure investments. Several, less senior officials, have served as paid consultants for Enron. The White House has given lawmakers access to thousands of pages of secret documents relating to Enron.