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Corporate giant Enron collapsed in 2001, sending shockwaves throughout the economy. Enron’s stock peaked at just above $90 in August 2000; but by the time the company declared bankruptcy in December 2001, its stocks were trading at $0.26. Estimated losses from the Icarian fall amount to $74 billion. This Icarian fall is commonly referred to as the Enron Scandal, and the damage it caused to employees, as well as shareholders and investors, remains in the minds of many.
source: New Mexico State University’s College of Business
We at the Zero Theft Movement are dedicated to eradicating the rigged parts of the U.S. economy so that the healthy parts can thrive for the public and businesses alike. Nipping economic foul play in the bud can prevent massive financial damage from events like the Enron scandal from occurring.
Enron’s Formation & Rapid Rise
Before we examine the events that led to the Enron scandal, we should take a look at the formation of Enron and how the company executed its rapid rise. This will provide a fuller picture of how Enron ultimately set it up for failure.
Formation of Enron
Enron was formed in 1985, with a $2.3 billion merger involving Houston Natural Gas Company and InterNorth Incorporated. Kenneth Lay, who had served as the CEO of Houston Natural Gas, took over as the chairman and CEO of the newly formed company.
Lay made two highly consequential decisions pretty early into his time as Enron’s chairman and CEO:
- Rebranding Enron into an energy trader and supplier
- Appointing McKinsey & Company ‘alumnus’ Jeffrey Skilling to head the newly created Enron Finance Corporation
The subprime mortgage crisis that followed the Lehman Brothers collapse reportedly cost $10 trillion in productivity, according to a Government Accountability Office report. Find out what role insurance giant AIG played in the crisis.
Energy Exploitation?
Energy markets experienced extensive deregulation during the 1990s, opening up the market to wholesale providers. Companies could also place bets on future prices now. With its new image and Skilling at the helm of the finance branch, Enron had positioned themselves to capitalize on a massive opportunity.
The company did so well that it reportedly owned about a quarter of the country’s total energy trading. That being said, Enron primarily focused on providing energy to California and allegedly contributed greatly to the power crisis in 2000-2001. The energy crisis resulted in blackouts and billions of dollars of surcharges to homes and companies alike all along the West Coast.
The New York Times reported on tapes leaked by officials from the Snohomish County Public Utility District in Washington State, claiming they contained “new details of market manipulation.” We have presented a few excerpts from the Times report and the tapes below:
“In one January 2001 telephone tape of an Enron trader the public utility identified as Bill Williams and a Las Vegas energy official identified only as Rich, an agreement was made to shut down a power plant providing energy to California…”
“This is going to be a word-of-mouth kind of thing,” Mr. Williams says on the tape. “We want you guys to get a little creative and come up with a reason to go down.” After agreeing to take the plant down, the Nevada official questioned the reason. “O.K., so we’re just coming down for some maintenance, like a forced outage type of thing?” Rich asks. “And that’s cool?”
The next day, Jan. 17, 2001, as the plant was taken out of service, the State of California called a power emergency, and rolling blackouts hit up to a half-million consumers, according to daily logs of the western power grid.”
“Officials with the Snohomish County Public Utility District in Washington State, which released the tapes, said they believed Enron officials had taken similar measures with other power plants. This tape, they said, was proof of what was going on.”
Financial Focus
By the end of the 1990s, the dot-com bubble had reached a fever pitch. NASDAQ ran up 1450% in a decade due to technology companies getting valued at unprecedentedly high levels. Many investors and regulators wrongly thought that the market had permanently changed, that this would be the new standard.
From DailyFX
Enron rode the wave, growing aggressively and winning the respect of much of the business world. For example, Fortune named the energy giant the most innovative company in corporate America six years in a row (1995-2000).
nasdaq 1990-2002
source: Begin to Invest
Such rapid growth often takes an aggressive trading strategy. Enron’s case simply proves the rule. Frank A. Wolak, an economics professor at Stanford University, writes: “Even in the competitive business of energy trading, Enron was known for its aggressive behavior. If there was a profitable trading strategy available because of a poorly designed regulatory rule, Enron was often the first market participant to formulate this strategy and profitably exploit it. Enron was also not shy in publicizing its many apparent profit-making actions in these markets.”
Accounts from Enron traders, surfacing after the company’s collapse, confirm Wolak’s claims. And perhaps make the company culture appear even worse than you might have already thought. The Market Watch article linked above states: “The traders said that Enron’s former president, Jeff Skilling, pushed them to ‘trade aggressively’ in California and to do whatever was necessary to take advantage of the state’s wholesale market to boost the price of Enron’s stock. The traders also said that Enron’s retail unit, Enron Energy Services, or EES, used the fear created by the blackouts to push large California businesses into more than $1 billion in long-term energy contracts.”
A Blockbuster Bust, Leading up to the Enron Collapse
The eventual Enron scandal and failure occurred due to its investment in the once-ubiquitous video rental chain Blockbuster and a poor choice to construct high-speed broadband telecom networks.
In July 2000, Enron Broadband Services and Blockbuster agreed to a 20-year exclusive deal to take over the emerging video on demand (VOD) market. The partnership came to an embarrassing end just eight months after the deal had been inked. But somehow, according to research by professors Paul M. Healy and Krishna G. Palepu, Enron supposedly “recognized estimated profits of more than $110 million from the Blockbuster deal, even though there were serious questions about technical viability and market demand.”
These questionable financial reports were, in retrospect, huge red flags, signaling Enron likely wasn’t doing as well as it seemed. But more on this later.
Despite the dot-com bubble bursting around 1999, Enron’s market stock remained strong. As we mentioned in the introduction, it hit its peak of $90.56 in August 2000 (a month after the Blockbuster deal). Most of the technology market experienced serious dips. Companies cut spending budgets for telecom services and equipment, and technology stocks plummeted.
But call it overconfidence, hubris, poor decision making. Enron doubled down on its technological pursuits when it started to build high-speed broadband telecom networks. What Enron executives thought would raise the company’s stock by $40 billion ended up bringing in a measly (relatively speaking) $16 million.
Combine all of these failed endeavors with Enron’s exposure to most volatile parts of the market (i.e. technology stocks), and you get a blockbuster bust. But somehow, the company appeared like it was fine…until it utterly collapsed.
Long-Term Capital Management (LTCM) company’s trading strategies eventually failed catastrophically and led to a $3.65 billion bailout in 1998. Should the government have intervened as the lender of last resort? See what the ZT community has uncovered…
The Enron Scandal
By mid-2001, Enron’s market value was rapidly falling. CEO Kenneth Lay had left the ship before it started sinking in February. Skilling had taken Lay’s place, but resigned in August 2001. Lay actually came out of retirement to take over Enron again.
When Enron released its quarterly report on October 16, the end appeared apparent. The company announced $1 billion in its first ever quarterly loss (as far as the public numbers go), and terminated its infamous ‘Raptors’ (more on this later).
The SEC, finding the collapse suspicious, opened its investigation in November 2011. As findings started to emerge, the Enron Scandal primarily revolved around how Enron kept up appearances so long.
The agency’s investigation, as well as countless other post mortems, point to two main techniques that allegedly allowed Enron to hide its losses:
- Mark-to-market (MTM) accounting
- Special purpose entities
Mark-to-market accounting
Masking the failures of Enron was a technique called mark-to-market (MTM) accounting. This became one of the key components of the Enron scandal.
Mark-to-market accounting refers to the method of measuring the value of an asset based on the current market price or ‘fair value,’ instead of the book price. Although ironic in the case of the Enron scandal, mark-to-market generally gives a realistic appraisal of an institution’s or company’s current financial status based on market conditions at that point in time.
True to its aggressive strategy, Enron wanted to switch to mark-to-market accounting and sought out the approval of the Securities and Exchange Commission (SEC). The regulatory agency, after some back and forth, approved the switch in 1992.
So, how can some exploit MTM? The questions that follow are, who’s setting the market price, and what are they basing that price on?
Imagine if a company signs a lucrative partnership deal that might revolutionize a service or shells out millions to build a nationwide broadband network. Would you go off what the current value of the company is? Or would you set the company’s market value based on how much profit you think these prospects will generate?
The aforementioned paper conducted by professors Healy and Palepu argues that “Enron entered into a $1.3 billion, 15-year contract to supply electricity to the Indianapolis company Eli Lilly. Enron was able to show the present value of the contract, reportedly for more than half a billion dollars, as revenues. Enron then had to report the present value of the costs of servicing the contract as an expense. However, Indiana had not yet deregulated electricity, requiring Enron to predict when Indiana would deregulate and how much impact this would have on the costs of servicing the contract over the ten years…”
But as we know, many of Enron’s ventures ended up failing. So where did the losses go?
Special purpose entities
To conceal its losses, Enron allegedly used special purpose entities.
Special purpose entities (SPEs), or special purpose vehicles, refer to a subsidiary formed by a parent company to separate financial risk. Because SPEs, under law, are considered its own entity, its obligations remain safe if the parent company goes bankrupt (and vice versa).
Professor of Law at Duke University Steven L. Schwarcz published an essay investigating Enron’s “use and abuse of special purpose entities” as shell companies to hedge investments.
“In a typical transaction, Enron would transfer its own stock to an SPE in exchange for a note or cash, and also directly or indirectly guarantee the SPE’s value. The SPE, in turn, would hedge the value of a particular investment on Enron’s balance sheet, using the transferred Enron stock as the principal source of payment…When Enron’s stock price subsequently fell, the SPE’s value also fell, triggering the Enron guarantees; these guarantee payments in turn apparently further reduced Enron stock value, triggering additional guarantees.”
The issue, according to Schwarcz, was Enron funded its hedges with its own stock and financial guarantees. Thus, Enron’s plummeting stock and illiquid investments were supposedly tied to hundreds of SPEs by 2001, according to Healy and Palepu.
Court Cases After the Enron Scandal
Regulatory authorities thoroughly investigated the company and brought charges to most, if not all, Enron executives. We cover what happened to three of the main figures after the Enron scandal, but you can see the results of other investigations here.
As an aside, Arthur Andersen, the now-defunct accounting firm that handled Enron’s books, was indicted for obstruction of justice. Per ABC News, “The obstruction charge is based on claims that Andersen employees shredded important documents about Enron’s finances, even though they knew the Securities and Exchange Commission was formally looking into Enron. The Justice Department also alleges Andersen employees deleted relevant computer files.”
Kenneth Lay
On July 8, 2002, the ruling from Lay’s court case was announced. A federal grand jury in Houston indicted Lay on charges of conspiracy, securities fraud, wire fraud, bank fraud and making false statements.
According to the FBI press release linked above, “Starting in August, according to the indictment, Lay was briefed extensively about mounting and undisclosed financial and operational problems, including overvaluation of Enron’s assets and business units by several billion dollars. As a result of these and other issues confronting Enron, Lay privately considered a range of potential solutions, including mergers, restructurings, and even divestiture of Enron’s pipelines, assets that Lay considered to be the crown jewels of the company. However, the indictment alleges he failed to disclose Enron’s problems to the investing public and affirmatively misled the investing public about Enron’s financial condition, while falsely claiming that he was disclosing everything that he had learned.”
On July 5, 2006, Lay, however, passed away before the trial could take place. A federal judge vacated all charges against Lay, preventing the government from retrieving $43.5 million in allegedly ill-gotten gains.
Jeffrey Skilling
A 2004 SEC press release revealed the agency’s complaints against Skilling: “…[He] and others improperly used reserves within Enron’s wholesale energy trading business, Enron Wholesale, to manufacture and manipulate reported earnings; manipulated Enron’s “business segment reporting” to conceal losses at Enron’s retail energy business, Enron Energy Services (“EES”); manufactured earnings by fraudulently promoting Enron’s broadband unit, Enron Broadband Services (“EBS”); and improperly used special purpose entities (“SPEs”) and the LJM partnerships to manipulate Enron’s financial results…Skilling made false and misleading statements concerning Enron’s financial results and the performance of its businesses, and that these misrepresentations were also contained in Enron’s public filings with the Commission…Skilling sold Enron stock while in possession of material, non-public information that generated unlawful proceeds of approximately $63 million.”
A federal jury, according to NBC News, “convicted him on 19 out of 28 criminal counts including fraud, conspiracy, and insider trading. He was sentenced to 24 years in prison and ordered to forfeit $45 million.”
CFO Andrew Fastow
According to an SEC complaint, Fastow (along with other executives) “devised a scheme [in 1997] to defraud Enron’s security holders through transactions with certain Enron SPEs.”
In 2004, the DOJ announced that “Fastow [had] pleaded guilty to two counts of conspiracy, in violation of 18 U.S.C. § 371….As part of his plea agreement, Fastow agreed to serve 10 years in prison and to cooperate fully with the government’s ongoing criminal investigation of the collapse of the Enron Corporation…Fastow admitted that he and other members of Enron’s senior management conspired in wide-ranging schemes to fraudulently manipulate Enron’s publicly reported financial results. Fastow also admitted participating in schemes to enrich himself at the expense of the company and its shareholders. Specifically, Fastow admitted that he conspired with senior management to cause Enron to enter into improper transactions with the LJM entities, which were under Fastow’s control. And he admitted to engaging in self-dealing transactions to enrich himself and others in connection with the so-called Southampton transaction which involved the $30 million buyout by Enron of an entity called LJM Swap Sub, LP, which Fastow controlled. In engaging in these transactions, Mr. Fastow admitted that he violated his duty of loyalty and honest services to Enron’s shareholders.”
Did the Enron Scandal Lead to Regulatory Reform?
Perhaps wide scale economic reform would not have occurred if the Enron scandal alone had damaged the economy. The fall of a telecom giant in the Worldcom scandal, as well as the dot-com bubble bursting, sparked new regulations and legislation to improve the transparency in financial reporting for publicly held companies.
For example, George W. Bush signed the Sarbanes-Oxley Act (SOX) in 2002. The legislation established the following main protections:
- Make audit committees more prevalent
- Mandating public companies establish strong internal controls
- Limiting the number of Board members who are certified public accountants to a maximum of two
- Increasing criminal penalties for securities fraud
- Enforcing a change in a company’s audit partners every five years
Furthermore, the Financial Accounting Standards Board (FASB) significantly increased its standards of ethical conduct to tighten loopholes further.
The Undeserving Losers of the Enron Scandal
While company executives allegedly sold off millions in company shares before the Enron scandal, many innocent employees and investors had to suffer serious losses.
CNN reports that tens of thousands of employees collectively lost more than $2 billion in retirement funds. Investors, fooled by Enron’s surging numbers, lost billions as well. And you’d be hard pressed to chalk these losses up to the natural ups and downs of the stock market. Shareholders received $7.2 billion in a settlement with the company.
Major financial crises, such as the Enron scandal, often involve moral hazards that ultimately end with the public unwittingly holding the bag. But how can you protect yourself and the public as a whole?
DID YOU KNOW?
According to a 2013 study by Vanderbilt University professor Mark A. Cohen, total victimization costs of white-collar crime exceed $1.6 trillion, excluding psychological costs and many other monetary damages. Compare that to street crime victimization costs, which were estimated to be $833.8 billion in 2012.
Protect the Public with the Zero Theft Movement
You can protect yourself and the rest of the public from crises such as the Enron scandal.
On the Zero Theft voting platform, citizens author theft proposals, and the community decides whether those investigations have convincingly proven (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where crony capitalism is thriving and start working on addressing them systematically.
Standard Disclaimer
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since Congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.