Enron Scandal: Fraud, SPEs, and Corporate Collapse

Introduction and Background

Once upon a time, there was an enterprise called Enron. It was a leading energy company headquartered in Texas with offices throughout the world. One fall morning in 2001, this large corporation — with thousands of employees and stockholders — imploded after an exhaustive effort to hide the company's financial losses. No single collapse of a corporation has affected America and the world in the manner that the demise of Enron did. The demise of the company not only affected thousands of employees and stockholders but also jeopardized the retirement funds of many others. There are many reasons the company collapsed, including deceitful accounting methods and a select group of employees who refused to tell the truth about the company's condition. In any case, many questions remain unanswered concerning the ability of the company to avoid detection for so long.

The purpose of this discussion is to explore how a company can look so good on paper but ultimately disintegrate. The paper seeks to explain the tactics that Enron used to evade detection and mislead investors. The financial dealings of the company and the actions that leading executives played in perpetuating such a facade are examined in depth. The discussion also focuses on the issue of business ethics and the thought processes employed in making these terrible decisions, and brings attention to the thousands of people affected by Enron's practices.

In 1985, Enron was formed through the merger of Houston Natural Gas, a Texas pipeline company headed by Ken Lay, and InterNorth, a larger Nebraska-based pipeline group. Sam Segnar, CEO of InterNorth, headed the new company until his resignation during a reorganization in 1986. Kenneth Lay then assumed the top position, which he held until he resigned under pressure on January 23, 2002.

Ken Lay, who held a doctorate in economics, saw the potential of natural gas deregulation in the 1980s. However, during the late 1980s Enron struggled as a pipeline company in a period of plummeting natural gas prices. According to an article in the Journal of Accountancy, this struggle was fueled by the fact that Enron incurred a large amount of debt as a result of the merger; in addition, deregulation meant that the company no longer had exclusive control over its pipeline (Thomas 2002). For these reasons, the company was on the verge of failing and was forced to create an innovative organizational strategy to generate cash flow and profits (Thomas 2002).

To combat this situation, Enron hired Jeffrey Skilling in 1990. Skilling was working as an energy trader handling the Enron account for McKinsey and Company. Skilling, a Harvard Business School graduate, had a vision of turning Enron into a fast-moving energy trading company with few hard assets such as natural gas fields, pipelines, and power plants. Together, Lay and Skilling started to transform Enron into one of the largest, most respected companies in the world.

Under Lay and Skilling, Enron grew quickly, constantly moving into new markets and businesses. Skilling led the transformation of the corporate culture into a highly aggressive, innovative, and creative place to work. Enron prided itself on hiring the "best people." A company-wide performance review system was designed to weed out the poorest performers. Each person was evaluated and ranked against other employees in similar positions. Bonuses and promotions were based on employees' rankings. According to Thomas (2002), this ranking system was one of the most stringent systems of evaluating employees in corporate America. The system was referred to as the "360-degree review," which had its foundation in Enron's stated values of respect, integrity, communication, and excellence (RICE) (Thomas 2002). Because of the structure of this ranking system, individual performance was paramount while teamwork was not. The goal was making money at any cost. The measuring stick of success was the ever-increasing stock price driven by continued growth, regardless of risk.

In addition to Skilling, another key player entered the company: Andrew Fastow (Thomas 2002). Fastow was 29 and a Kellogg MBA when he began working for the company (Thomas 2002). Prior to coming to Enron, he worked for Continental Illinois Bank in Chicago coordinating leveraged buyouts and other complex transactions (Thomas 2002). Thomas (2002) reports that "Fastow became Skilling's protégé in the same way Skilling had become Lay's. Fastow moved swiftly through the ranks and was promoted to chief financial officer in 1998. As Skilling oversaw the building of the company's vast trading operation, Fastow oversaw its financing by ever more complicated means (Thomas 2002)."

Enron's 2000 annual report touted their 15-year history of growth by writing: "we have stretched ourselves beyond our own expectations . . . metamorphosing from an asset-based pipeline and power generating company to a marketing and logistics company whose biggest assets are its well-established business approach and its innovative people."

During the dot-com stock market growth of the 1990s, Enron's reputation as a low-asset, idea-based company played very well with stock market investors who continued to bid up Enron stock. Reported earnings per share continued to increase, supporting Enron's ever-increasing stock price. Enron's 2000 annual report stated, "earnings per share have increased steadily since 1997 and were up 25% in 2000 (and) the 10-year return to Enron shareholders was 1,415% compared with 383% for the S&P 500."

By 2001, Enron was ranked the seventh largest company in the United States. The company had changed from a gas pipeline company to an energy trading company and then to a company based on trading oil, gas, water, minerals, forest products, broadband, and anything else it could make a commodity. As Enron grew larger, it had to generate more earnings to support its increasing stock price. At some point in the late 1990s, Enron began trading derivatives.

Derivatives allow investors to speculate with other investors on the future price of an underlying asset, such as oil, electricity, or weather-related indexes. When properly used, derivatives provide an effective hedge against future business risks such as hikes in oil prices, changes in interest rates, weather-caused increases in energy usage with accompanying higher energy prices, and any other variable that could affect the value of underlying contracts. Although derivatives can be used to reduce risk, they are very precarious and can greatly exaggerate market gains and losses. The unpredictable and risky nature of derivatives was described as follows:

"Derivatives can be risky for several reasons. The major reason is that investors can use derivatives to take larger risks than they could otherwise obtain by the use of capital to directly purchase securities or other assets. Another reason is that derivatives, even when used to reduce or hedge risk, create new risks in the form of credit risk. Credit risk is the exposure to a counterparty's inability to fulfill the derivative contract. Yet another risk is that derivatives markets can become illiquid and prevent market participants from adjusting or unwinding their positions" (Untangling Enron: The Reforms We Need, 2002).

Over time, Enron continued to increase the volume of its derivatives trading until, at the end, the company had seemingly become a massively complex derivative trading enterprise.

Enron could engage in derivative trading with no fear of government intervention because derivative trading was specifically exempted from government regulation. Due in part to a ruling by the Commodity Futures Trading Commission's (CFTC) chairwoman, Wendy Gramm, derivatives remained free of regulatory oversight. Ms. Gramm, wife of Texas senator Phil Gramm, made this ruling five weeks before resigning as chairwoman of the CFTC and joining the Enron Board of Directors in 1993.

Derivative accounting is further complicated because there is no consistent way to fairly report their value and risk in a company's financial reports. In 1998, Rule No. 133, "Accounting for Derivative Instruments and Hedging Activities," was developed by the Financial Accounting Standards Board (FASB), an independent agency that sets guidelines for corporate auditors. Rule 133 contains more than 800 pages, which further complicates its adoption and consistent interpretation by various companies. SFAS No. 133 was subsequently amended by SFAS rules 137 and 138. These rules must be applied to all "derivative instruments and certain derivative instruments embedded in hybrid instruments" and require that such instruments be recorded in the balance sheet either as an asset or liability measured at fair value through earnings, with special accounting allowed for certain qualifying hedges. In its 2000 annual report, Enron stated that it would adopt SFAS No. 133 as of January 1, 2001 and that, due to this adoption, "Enron (would) recognize an after-tax non-cash loss of approximately $5 million in earnings and an after-tax non-cash gain . . . of approximately $22 million . . . (and) will also reclassify $532 million from long-term debt to other liabilities."

Derivative trading to hedge risk was carried out with related-party Special Purpose Entities. According to an article in The CPA Journal, a Special Purpose Entity (SPE) "is a trust, corporation, limited partnership, or other legal vehicle authorized to carry out specific activities as enumerated in its establishing legal document." An SPE supplies its guarantor with liquidity and financing while giving creditors protection against the guarantor's bankruptcy. Usually a sponsor creates an SPE to carry out a specific function through an asset transfer. The journal presents an example: "an SPE might borrow cash from a third-party creditor. In exchange for that cash, the sponsor sells an asset to the SPE and then leases it back under an operating lease (sale-leaseback). Under certain circumstances, the debt used by the SPE to acquire the asset would be its own liability and would not appear on the sponsor's balance sheet (Holtzman et al., 2003)."

Enron's View of Itself and Media Depiction

Holtzman et al. (2003) also explain that businesses may use SPEs to gain entrance into capital markets and to control risk. For instance, "an SPE might issue debt or equity, using the proceeds to acquire financial instruments (such as home mortgages) from its sponsor. Such a transfer of financial assets, if it qualifies as a sale or purchase, lowers the sponsor's cost of capital, because it isolates the assets from the risk of sponsor bankruptcy. Loan underwriters and credit-rating agencies often require business entities involved in synthetic leasing and commercial mortgage-backed securities to be SPEs (Holtzman et al., 2003)."

Additionally, the transferor usually derives a tax advantage because the SPE is a pass-through entity that does not pay its own taxes. Businesses usually establish SPEs because the benefits of lower financing costs, lower taxes, and off-balance-sheet financing usually outweigh the cost of establishing and managing the SPE (Holtzman et al., 2003). "In short, the SPE was designed, in part, to minimize risk, but also to bypass accounting treatments that would otherwise increase leverage and decrease earnings (Holtzman et al., 2003)."

In Enron's case, the SPEs were created to allow the company to transfer assets, hide losses, provide a method of recognizing the increased value of its stock on its financial statements, and create the impression that Enron had hedged its gains in stock and other assets. The most controversial SPEs were headed by Enron employees who realized an incredible return on their small investments in the SPEs. The SPEs were supposed to be structured and run so that their results did not have to be consolidated on Enron's financial statements. To achieve this, the SPEs were supposed to have outside investments of at least 3%, the investment should be at risk, and the SPEs should be independent. In reality, Enron provided more than 97% of the funding so the SPEs had little to no risk. The SPEs gave the appearance of hedging Enron's gains, but in fact Enron was really hedging its own gains and insuring against its own losses. This system worked well as long as stock prices kept going up, but when they started to drop the losses became overwhelming. Enron had to declare bankruptcy.

What no one realized was the depth of the problem Enron had created for itself, due in large part to individual and corporate greed. The very system that the company had created to improve the performance of employees became a system full of deceit and secrecy. Thomas (2002) asserts that employees began to believe that "the only real performance measure was the amount of profits they could produce. In order to achieve top ratings, everyone in the organization became instantly motivated to 'do deals' and post earnings. Employees were regularly rated on a scale of 1 to 5, with 5s usually being fired within six months. The lower an employee's PRC score, the closer he or she got to Skilling, and the higher the score, the closer he or she got to being shown the door. Skilling's division was known for replacing up to 15% of its workforce every year. Fierce internal competition prevailed and immediate gratification was prized above long-term potential. Paranoia flourished and trading contracts began to contain highly restrictive confidentiality clauses. Secrecy became the order of the day for many of the company's trading contracts, as well as its disclosures (Thomas 2002)."

In his article, Jackson asserts that the methods used to review employee performance created an environment in which people were afraid to anger those who might affect their reviews (Jackson). Progressively the culture transformed into a "yes-man" environment (Jackson). In addition, Jackson contends that Andrew Fastow had a reputation for using the review system as a bludgeon to retaliate against those who voiced opposition (Jackson).

This mindset ultimately led to the debacle that was Enron. Top-level executives became so greedy that they did not consider the ramifications of their actions. They developed such an inflated view of the company's condition that they could not see the mess that had been created as a direct result of their decisions.

By the year 2000, the company had succeeded in creating a particular view of itself that was appealing to investors. For instance, on the first page of Enron's 2000 annual report was the following description of how the corporation perceived itself and its future:

"Enron manages efficient, flexible networks to reliably deliver physical products at predictable prices. In 2000 Enron used its networks to deliver a record amount of physical natural gas, electricity, bandwidth capacity and other products. With our networks, we can significantly expand our existing businesses while extending our services to new markets with enormous potential for growth."

The 2000 financial highlights portrayed a company with accelerating revenues, net income, total assets, and, most importantly, stock prices. During 2000, Enron stock prices ranged from a low of 41 3/8 to a high of 90 9/16, with a year-end close of 83 1/8. Another graph in the annual report compared Enron's cumulative total return through 2000 with that of the S&P 500. Over one year, Enron reported an 89% return compared to the S&P 500's 9%.

Ken Lay's and Jeffrey Skilling's letter to shareholders in the 2000 annual report painted a rosy picture of past successes and unlimited potential for future growth:

"Enron's performance in 2000 was a success by any measure, as we continued to outdistance the competition and solidify our leadership in each of our major businesses. In our largest business, wholesale services, we experienced an enormous increase of 59% in physical energy deliveries. Our retail energy business achieved its highest level ever of total contract value. Our newest business, broadband services, significantly accelerated transaction activity, and our oldest business, the interstate pipelines, registered increased earnings. The company's net income reached a record $1.3 billion in 2000."

The 2000 annual report gave no indication of trouble ahead, but by December 2001, Enron had been forced into Chapter 11 bankruptcy. Lay and Skilling had resigned. Enron had announced a loss of $1.01 billion after-tax for the third quarter of 2001, and the stock had been delisted from the NYSE when it traded below $1.00 for more than 30 days.

Even the media bought into the notion that Enron was a successful company. Powers et al. assert that "in the eyes of Wall Street and the business press, Enron was a classic 'new economy' company. It developed sophisticated financial trading technology, which impressed observers, and made intensive use of the Internet. Many of its ideas were sound and far-seeing. If derivatives in energy were traded legitimately, for example, it could help businesses and private energy users to reduce future uncertainties by enabling them to lock in costs — even costs that would arise ten years later. The use of the Internet to trade derivatives could result in generally lower prices for energy, say, by instantaneously matching many more buyers and sellers across wide geographical areas (Powers et al.)."

In the months prior to the collapse of Enron, respected business publications such as Forbes, Red Herring, and Fortune had good things to say about Enron. According to an article found in the Columbia Journalism Review, all of these publications featured positive stories about the company in the months just prior to its demise (Sherman 2002). Despite the imminent demise of the company, many business publications believed in the company until the end. Two months prior to the collapse, Forbes published an article stating, "Enron has grown into the world's largest electricity marketer since we last wrote about it. Now a new surge in revenues might be in the offing (Sherman 2002)." Other magazines followed suit. Sherman (2002) asserts that "In its September 2001 issue, Red Herring insisted: 'Forget about Microsoft. America's most successful, revered, feared — and even hated — company is no longer a band of millionaire geeks from Redmond, Washington, but a cabal of cowboy/traders from Houston: Enron.' For six years in a row, industry insiders voted Enron 'Most Innovative' among Fortune's 'Most Admired Companies' — a list that purports to be 'the definitive report card on corporate reputations.' In January 2000, Business Week showcased Kenneth Lay as one of the '25 Top Managers' of 2000. Lay and Skilling stood out in Worth's annual surveys of the '50 Best CEOs.' In 2001, Skilling — 'hypersmart, hyperconfident,' gushed Worth — garnered the number two position (Sherman 2002)."

In time it was revealed that Enron also paid certain outlets to report good news about the company. It was discovered that political commentators and journalists alike were paid handsome fees by Enron. One such journalist was Paul Krugman, a writer for Fortune (Powers et al.). The authors assert that "well before Enron collapsed, Krugman, who once praised the company and then began to severely criticize it, voluntarily disclosed that he had received money from Enron (Powers et al.)." In addition, Irwin Stelzer (contributor to The Standard), William Kristol (Weekly Standard), and Lawrence Kudlow (CNBC) all received payment from Enron. Powers et al. asserts that Kristol was given $100,000 while other commentators were paid less. The authors assert, "Enron also invited individual investment bankers to participate personally in its lucrative partnerships. It needed those bankers' help to raise millions from unsuspecting investors. Enron peddled influence in the same way it peddled gas, and seemingly made no distinction between the two (Powers et al.)."

However, some business publications painted a more realistic picture of the company. Sherman (2002) reports that both The Economist and Business Week refrained from worshiping the company. The Economist had a more pragmatic approach, suggesting that Enron's lobbyists were pushy and promoted an agenda to dominate the electricity market (Sherman 2002). The magazine also made note of Lay's inability to admit his faults. Nevertheless, neither publication ever investigated the financial dealings of the company (Sherman 2002).

However, there was one journalist, Jonathan Weil of The Wall Street Journal, who decided to investigate the company (Sherman 2002). His desire to do so was fueled by a source who encouraged him to investigate both Enron and another energy company. After some investigation, Weil reported the following:

"Volatile prices for natural gas and electricity are creating high-voltage earnings growth at some companies with large energy-trading units. But investors counting on these gains could be in for a jolt down the road. What many investors may not realize is that much of these companies' recent profits constitute unrealized, noncash gains. Frequently, these profits depend on assumptions and estimates about future market factors, the details of which the companies do not provide, and which time may prove wrong. The heart of the situation is an accounting technique that allows companies to include as current earnings those profits they expect to realize from energy-related contracts and other derivative instruments in future periods, sometimes stretching over more than 20 years (Sherman 2002)."

Enron: Organization, Markets, and Financial Results

The findings of Weil's investigation were never published in the national edition of The Wall Street Journal, but the findings certainly suggested that Enron had a great deal to hide and attempted to warn investors (Sherman 2002).

In the months and years following the collapse of Enron, many business publications and news outlets questioned their own inability to see past the deplorable accounting practices at Enron (Sherman 2002). One reporter explained that when a company is lying to the SEC and hires prominent lawyers and accountants to verify their business dealings, it is difficult to prove any wrongdoing (Sherman 2002). However, others concede that the media ignored several red flags that told of Enron's impending doom. According to Sherman (2002), these red flags included a longtime discrepancy between the profits and cash flow of the company, a return on investment considered low for such a high-risk business, financial statements that were difficult to understand, a mysteriously unraveled deal with Blockbuster in March 2001, and the resignation of Jeffrey Skilling in August 2001 — together a combination of smoking guns (Sherman 2002).

Another issue that arose from the Enron scandal was the unwavering positive remarks that business analysts made about Enron even when it became obvious that the company was in trouble. As Jonathan Weil noted, "Too frequently during the 1990s, financial journalists 'outsourced their critical thinking skills to Wall Street analysts, who are not independent and, by definition, were employed to do nothing but spin positive company news in order to sell stock.' There was hardly a Wall Street analyst covering the stock whose firm was not getting sprinkled with cash in some form or another by Enron (Sherman 2002)."

Charles Schwab's Equity Report Card describes Enron as a business that "produces electricity and natural gas, develops, constructs and operates energy facilities worldwide, and delivers physical commodities and financial and risk management services to customers around the world." Another source asserts that Enron consisted of two basic companies (Untangling Enron: The Reforms We Need, 2002). The first was an energy supply company that acquired actual physical assets such as electrical power plants and pipelines to provide energy. The other was a financial institution that performed as a key dealer in derivatives and wholesale transactions in energy products, other commodities, and some financial derivatives (Untangling Enron: The Reforms We Need, 2002).

Enron's business was divided into five segments: Transportation and Distribution, Wholesale Services, Retail Energy Services, Broadband Services, and Corporate and Other. Each segment is described as it appeared in Enron's 2000 annual report:

Transportation and Distribution. This segment consisted of Enron Transportation Services and Portland General. Transportation Services included Enron's interstate natural gas pipelines, primarily Northern Natural Gas Company, Transwestern Pipeline Company, Enron's 50% interest in Florida Gas Transmission Company, and Enron's interests in Northern Border Partners, L.P. and EOTT Energy Partners, L.P.

Wholesale Services. This segment included Enron's wholesale businesses around the world, operating in developed markets such as North America and Europe, as well as developing or newly deregulating markets including South America, India, and Japan.

Retail Energy Services. Through its subsidiary Enron Energy Services, LLC, Enron extended its energy expertise and capabilities to end-use retail customers in the industrial and commercial business sectors to manage their energy requirements and reduce their total energy costs.

Broadband Services. Enron's broadband services business provided customers with a single source for broadband services, including bandwidth intermediation and the delivery of premium content.

Corporate and Other. This segment included Enron's investment in Azurix Corp., which provides water and wastewater services; results of Enron Renewable Energy Corp. (EREC), which develops and constructs wind-generated power projects; and the operations of Enron's methanol and MTBE plants, as well as overall corporate activities.

The following are financial results reported in Enron's 2000 Annual Report. Even though the results from 1997–2000 had to be restated in November 2001, the stellar results Enron consistently reported were part of the reason no one investigated or questioned them. The optimistic future results touted in the annual report drove stock prices higher.

Financial highlights from the 2000 Annual Report (before restatement) include revenues rising from $13.289 billion in 1996 to $100.789 billion in 2000. Total assets grew from $16.137 billion in 1996 to $65.503 billion in 2000. Net income from operating results was reported at $1.266 billion for 2000. Cash from operating activities (excluding working capital) was reported at $3.010 billion in 2000 and capital expenditures and equity investments totaled $3.314 billion in 2000.