Introduction
The collapse of energy giant Enron is considered the largest bankruptcy and the most shocking failures in the US history. Since its formation in 1985, Enron grew to become one of the US largest companies in just over 15 years. It was even named the most innovative company by Fortune Magazine for six consecutive years and it seemed to be a shinning example of successful corporate America. But Enron’s success was based on artificially inflated profits, dubious accounting practices and even fraud. The company collapsed suddenly in December 2001, ruining the lives of its 21,000 employees worldwide and wiping tens of billions of shareholder investment and employee retirement investments.
2. Enron Business Background
Enron was originally involved in the transmission and distribution of electricity and gas throughout the United States and the development, construction and operation of power plants, pipelines etc worldwide. When Jeff Skilling joined Enron in 1989, he brought with him the idea that Enron could profit from trading future gas contracts between suppliers and consumers, effectively betting against future movements in the price of gas generated energy. Enron’s business was therefore basically buying and selling tomorrow’s gas at a fixed price today.
By late 1990’s Enron was the largest wholesale buyer and seller of natural gas and electricity in the world with a revenue increase of $5b to $7b. Enron then expanded its business by engaging in risky businesses such as weather derivatives, risk management, internet bandwidth to mention a few of them. Exactly what Enron’s business was trading in is complex to define. The former Enron CEO, Jeffry Skilling once described Enron as a “logistics company that ties together supply and demand for a given commodity and figures out the most cost effective way to transport that commodity to its destination.” As Enron expanded, there was little scrutiny on how it was managing the expansion and in deed how it was in fact making its money. By late 1999 Enron planned on moving to broadband internet networks and this appealed to investors and its share price soared, it became one of the first energy companies to trade through the internet and it gained a lot of profit from this venture. Naturally investors invested in the company and all seemed well. Although Enron boasted about the value of the products it traded online, nothing was said as to whether these were making any profit.
By then Enron had began using sophisticated accounting techniques to keep its share price high, raise its investment against its own stock and assets and maintain the impression of a highly successful company.
3. Enron’s Special Purpose Entities
At the core of Enron’s demise was the creation of partnerships known as Special Purpose Entities (SPE’s). These are body corporates created to fulfil a narrow, specific or temporary objective, primarily to isolate financial risk. Enron at the advice of its Chief financial Officer Andrew Fastow funded these SPE’s with outside investors, banks and even Enron money. The nature of SPE’s is such that the managers of SPE’s cannot be the same as the parent company to avoid conflict of interest and that they should be independent from the parent company. Enron however disregarded these rules.
Enron’s SPE’s were run by Enron’s executives who profited richly from them. Enron’s balance sheet would come under pressure due to its huge investments in risky businesses and subsequently Enron had substantial debt load. The SPE’s allowed Enron to keep millions of dollars of debt off its books and mask its financial problems and it continued to get cash and credit to run its trading business and deceive investors.
This practice drove up their share price to new levels, at which point the executives began to work on insider information and trade millions of dollars worth of Enron stock. The executives and insiders at Enron knew that the SPE’s were hiding losses for the company, but the investors knew nothing of this. It has been said that these partnerships consisted of a web of moving money to and from and in between companies to avoid detection that there was simply no money.
Enron’s use of SPE’s was subject to accounting rules that determine whether:
a) The entity should be consolidated in its entirety (including all its assets and liabilities) into Enron’s balance sheet; or instead
b) Be treated as an investment by Enron.
Enron Management had preferred the latter. Enron would engage in risky businesses and would pass off its debt as if it were that of the “independent” SPE’s. By so doing, Enron managed to legally remove its losses from its books and passed them to its SPE’s, and this allowed Enron to raise its share price.
During the dot.com boom, the value of products Enron traded in was estimated at $880bn. Enron’s 2000 Annual report stated that Enron’s global revenue stood at $100bn. Its share price soared to an all time high of more than $90 a share.
By late 2000, Enron was a world class company with worldwide network and market capitalisation of $36b and assets of over $65b of which $7.3b were in current assets and reportedly $ 288m in cash. Between 1996 and 2000 Enron had reported an increase in sales from $13.3b to $100.8b
4. ARTHUR ANDERSEN
Arthur Andersen was one of the five leading accounting firms in the world and was the auditor to Enron. The most important statutory duty of an independent auditor is to ensure that the financial reports give true and fair view of the company’s accounts. If financial statements contain fraud and irregularities, the independent auditor should discover this and report it to the proper authority. This role required Arthur Andersen to verify the accuracy of Enron’s books.
During yearly audits performed by external, independent auditors, checks are performed to make sure that the business is following the Generally Accepted Accounting Principles (GAAP). If they are not the business must show why they are not and present rational to demonstrate that what they are doing is both ethical and appropriate. These accounting principles are in place to make financial statements as accurate and reliable as possible.
Enron had found a way to circumvent these rules as it bolstered their balance sheet with inflated assets and dispersed their liabilities to their SPE’s which they did not include in their financial accounts at the end of the year, causing misstatements. Andersen did not detect this and even if it did it did not report this to the relevant authorities.
The Generally Accepted Auditing Standards (GAAS) are set down specifically for the audit cycle of the company. It tells auditors what tests they should do, to what extent testing should be done and what level is acceptable in the audit. According to the GAAS Auditors are to remain independent both in fact and in appearance. However, as Anderson took a very active role in Enron’s business through auditing and consulting and received exorbitant fees to the tune of $52m in one year, it overlooked its duty to ascertain Enron’s management understanding of the risk of fraud.
At the collapsed of Enron, Andersen was charged with obstructing justice because it instructed its employees to shred Enron documentation except for the basic ones. Andersen was also charged with improperly approving Enron’s SPE’s which Enron had used to hide its losses.
5. The fall of Enron
By early 2001 Enron stock had began to suffer in the wake of the dot.com deflation and the energy price instability. By August 2001 crisis had begun to unravel. Skilling was to resign only seven months after appointment to the position of CEO and this made investors uneasy and they began selling their shares. It was also revealed that Enron’s accounts were not making any sense and the SPE’s seemed to be the problem. It had also come to light that Enron had been using its stock to bet against its own future value. The SPE’s were created to support Enron when its investments failed, but when Enron’s investments and stocks turned bad, the SPE’s could not pay up because their capital was disappearing at the same time. The downward spiral could not be stopped and share prices keep falling. Without its shares investment, Enron could no longer keep up appearances.
Even though there was crisis, Mr. Lay assured investors that “all was well”. When the then CEO Skilling resigned, Lay replaced him stating “Absolutely no accounting issue, no trading issue, no reserve issue, no previously unknown problem issue” are involved.
Enron Vice President Sharon Watkins warned Kenneth Lay of the impending implosion of Enron due to its accounting irregularities. Worried and sceptical investors continued disposing off their shares in the wake of the departure of Skilling. Amid the selling, Kenneth Lay also exercised his option and sold some of his shares to the value of $2m. By October 2001, Enron was clearly in trouble and executives finally acknowledged their mistakes and consolidated the SPE’s within the company’s main accounts and the accounting scheme was revealed. Enron then announced first quarter loss of $618m and reduced its quoted assets by $1.01bn.
By November 2001 amid crashing share prices, Enron re stated its profits for the past four years and admitted inflating its profits by concealing its debt in the SPE’s. By late November 2001, Enron’s shares were trading at less than $1. Enron filed for bankruptcy protection in 2 December 2001. The energy giant had collapsed.
5.2 Enron’s Corporate Failures
What happened at Enron can be characterized as systematic corporate failure. Between 1993 and 2001, Enron’s senior management was found by the Permanent Subcommittee on Investigations (“the PSI”) of the Committee on Governmental Affairs, United States Senate to have failed in its duties in the following areas:
5.2.1. Fiduciary failure
It was found that the Board failed to safe guard the shareholders in that it witnessed numerous indications of questionable practices by Enron over several years, but chose to ignore them to the detriment of Enron shareholders, employees and business associates.
i) A given example is that of the L.JM, an unconsolidated SPE which produced over $2 billion funds inflow for Enron in only 6 months resulting in Enron’s gross revenues rising from $40 billion in 1999 to $100 billion in 2000. No Board member questioned them although the figures were striking.
ii) It was also found that overall the Board received substantial information about Enron’s plans and activities and explicitly authorized or allowed many of the questionable Enron strategies, policies and transactions.
5.2.2. High-risk accounting
Enron Board of Directors knowingly allowed Enron to use High-risk accounting practices. This was so despite several instances where Andersen advised the Audit Committee that Enron was engaging in accounting transactions that could be deemed high-risk.
It is said that on February 7, 1999, Andersen informed the Audit Committee members that Enron was engaged in accounting practices that “push limits” or were “at the edge” of acceptable practice. Enron however continued to engage in these practices.
5.2.3. Inappropriate conflicts of interest
It has also been found that despite clear conflicts of interest, Enron approved an unprecedented arrangement allowing Enron’s Chief Financial Officer to establish and operate the LJM private equity funds which transacted business with Enron and profited at Enron’s expense. The Board exercised inadequate oversight of LJM transaction and compensation controls and failed to protect Enron shareholders from unfair dealing.
5.2.4. Extensive undisclosed off-the-books activity
The Enron Board of Directors knowingly allowed Enron to conduct billions of dollars in off-the-books activity to make its financial condition appear better than it was, and failed to ensure adequate public disclosure of material off-the-books liabilities that contributed to Enron’s collapse.
It was established that Enron’s multi-billion dollar, off-the-books activity was disclosed to the Enron Board and received Board approval as an explicit strategy to improve Enron’s financial statements.
5.2.5. Excessive compensation
It has been established that Enron’s philosophy was to provide “extraordinary rewards for extraordinary achievement.” The Enron Board of Directors approved excessive compensation for company executives. Enron’s Board failed to monitor the cumulative cash drain caused by Enron’s 2000 annual bonus and performance unit plans, and even failed to monitor or halt abuse by Board Chairman and Chief Executive Officer Kenneth Lay of company financed, multi-million dollar personal credit line.Enron also provided its executives with lavish compensation, on more than one occasion, it paid tens of millions of dollars to a single executive as a bonus for work on a single deal. In 2000, it is believed that Lay’s total compensation exceeded $140 million.
5.2.6. Lack of independence
The independence of the Enron Board of Directors was compromised by financial ties between the company and certain Board members. The Board also failed to ensure the independence of the company’s auditor, allowing Andersen to provide internal audit and consulting services while serving as Enron’s outside auditor.
The Enron Board and its Audit Committee were criticized for inadequate oversight to ensure the independence and objectivity of Andersen in its role as the company’s outside auditor. It has been established that Enron paid board members for consultancy services they did for Enron. In terms of auditor independence Arthur Andersen was found to have been actively involved in Enron to a point where certain auditing practices were omitted or overlooked.
6. Charges and Convictions
There were 29 Defendants charged in the collapse of Enron. The key players were:
a) Jeffrey Skilling former CEO who was charged with 35 counts of fraud, insider trading and was sentenced to 24 year in prison;
b) Andrew Fastow, former Chief Financial Officer who was charged with 78 counts of fraud, money laundering and conspiracy. He was sentenced to 6 years in Prison;
c) Kenneth Lay, founder of Enron who was charged with 11 counts of securities fraud and was convicted, but died before sentencing. His conviction was vacated in 2006 after his death.
7. POST ENRON - CORPORATE GOVERNANCE LESSONS
“There was a fundamental default of leadership and management. We found a systematic and pervasive attempt by Enron’s management to misrepresent the company’s financial condition” William Powers – headed Enron’s own internal investigation into the crash.
A number of lessons should be leant from the Enron’s collapse and they can be stated as follows:
Lesson 1: the importance of “old economy” questions: How does the company actually make its money? Is it sustainable? Is it legal?;
Lesson 2: The importance of accounting oversight;
Lesson 3: non Executive Directors must no longer just attend meetings; they must also understand the business at hand and question activities;
Lesson 4: Dangers of weak system and controls;
Lesson5: Most importantly the role and independence of external independent auditors.
8. Sarbanes-Oxley Act
The Sarbanes-Oxley Act of 2002 was enacted on July 30, 2002, largely in response to a number of major corporate and accounting scandals including Enron. Sarbanes-Oxley establishes new standards for corporate accountability as well as penalties for corporate wrongdoing. Although Sarbanes-Oxley has implications beyond the US borders, South African companies unless registered with the US Security Exchange Commission, will not be directly affected by this Act. Nevertheless, some key lessons may be taken notice of and some of the best practices adapted in South Africa.
The Act makes the following changes:
- audit partners must be rotated every five years;
- audit firms may not supply services to a company whose CEO and chief accounting officers were employed by the auditor and took part in an audit of the issuer within the preceding year;
- requires the reimbursement of gains from stock options if the earnings are retrospectively re stated;
- prohibits share sales by top officers during pension black outs;
- prohibits loans to top corporate officers;
- imposes duty to disclose information concerning material changes in the financial conditions or operation of the company;
- Introduces a tighter definition of non executive director.
9. Conclusion
“I think that the failures of Enron and other companies are partially failures of investors to recognize companies that are selling for a thousand times nothing, but chances are they may be worth only that.”
Arthur Levitt
Arthur Levitt
