Enron scandal

• 1. Introduction

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  The Enron scandal has plenty of large numbers, but one of the plainest is thirty minutes. That was how long thousands of employees were given to pack their belongings and leave the building on the day their American energy company filed for bankruptcy.

  Not long before, Enron stock had traded as high as $90.75 a share. By the end of November 2001, it was worth less than one dollar.

  How did a company so widely admired hide billions of dollars in debt? Who inside the boardroom and the accounting firm knew what was happening? And what became of the people who had trusted Enron with their savings?

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• 2. Pipelines to Trading

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  In 1985, Kenneth Lay merged two natural gas pipeline companies, Houston Natural Gas and InterNorth, and created a multi-billion dollar business. A year later it took the name Enron. The timing proved lucky. In the early 1990s Lay helped start the sale of electricity at market prices, and soon afterward Congress approved legislation deregulating natural gas sales. The new markets let traders such as Enron sell energy at higher prices, and its revenue climbed. Producers and local governments complained about the price swings and asked for regulation. Strong lobbying by Enron and others kept it from happening.

  Jeffrey Skilling first joined the company as a consultant and rose to chief operating officer. With his help, Enron changed from a gas producer and supplier into a trader of energy derivative contracts. By 1992 it was the largest seller of natural gas in North America. Trading gas contracts alone earned $122 million before interest and taxes, the second largest contributor to its net income. In November 1999 the company launched EnronOnline, a trading website that helped it manage its contract business.

  Growth was the goal, and diversification was the method. Enron owned and operated gas pipelines, electricity plants, paper plants, water plants and broadband services around the globe. It also traded contracts in all of those areas. It built power plants in developing countries and emerging markets, including Subic Bay in the Philippines, Indonesia, and Dabhol in India.

  The bull market of the 1990s fed the ambition. From the start of the decade to the end of 1998, Enron's stock rose 311 percent, only modestly more than the Standard & Poor 500 index. Then it pulled away. The stock gained 56 percent in 1999 and another 87 percent in 2000, while the index rose 20 percent and then fell 10 percent. On the 31st of December 2000, the shares stood at $83.13. Market capitalization topped $60 billion, which was 70 times earnings and six times book value. Fortune's Most Admired Companies survey named Enron the most innovative large company in America. Few of the investors paying those prices asked how the revenue behind them was being counted.

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• 3. Accounting Choices

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  Trading firms such as Goldman Sachs and Merrill Lynch reported only their trading or brokerage fee as revenue. Accountants call this the agent model, because the firm acts as a go-between and does not carry the full risk of the deal. Enron took the merchant route instead. A merchant that bears the risk of buying and selling may report the whole selling price as revenue. Enron applied that approach to the entire value of each trade. The merchant model was considered much more aggressive.

  Rivals followed to stay competitive. Duke Energy, Reliant Energy and Dynegy all joined Enron among the fifty largest companies in the revenue-based Fortune 500, mainly because they adopted the same method. Between 1996 and 2000, Enron's revenues grew from $13.3 billion to $100.7 billion, an increase of more than 750 percent. That works out to about 65 percent a year, in an industry where 2-3 percent was considered respectable. For the first nine months of 2001 alone, Enron reported $138.7 billion in revenues, enough for sixth place on the Fortune Global 500.

  Before Skilling arrived, accounting in the gas business was simple. Each period, the company listed the actual costs of supplying gas and the actual revenues from selling it. Skilling demanded that the trading business adopt mark-to-market accounting, saying it would show "true economic value". The Securities and Exchange Commission approved the method for Enron's trading of natural gas futures contracts on the 30th of January 1992. Enron became the first nonfinancial company to use it for complex long-term contracts.

  Under mark-to-market, once a long-term contract was signed, its income was estimated as the present value of the net future cash flow. Those estimates were hard to make. Reported profits could run far ahead of actual cash, and income could be booked on money Enron might never receive. The method also had a built-in appetite. Profits could not be counted twice, so new deals had to replace old ones. One competitor put it this way: "If you accelerate your income, then you have to keep doing more and more deals to show the same or rising income."

  Enron later spread the method beyond gas to help meet Wall Street's projections. In July 2000, Enron and Blockbuster Video signed a 20-year agreement to bring on-demand entertainment to various U.S. cities by the end of the year. After several pilot projects, Enron claimed estimated profits of more than $110 million. Analysts questioned whether the service was technically viable and whether customers wanted it. The two parties withdrew in March 2001. Enron kept claiming future profits anyway, even though the deal had lost money.

  Losses from deals like that one needed somewhere to go, and Enron built the places: partnerships with names such as Chewco.

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• 4. Hidden Debt

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  By 2001, Enron had used hundreds of special purpose entities to hide its debt. These were limited partnerships or companies set up for a temporary or specific purpose, such as funding assets or managing their risks. A sponsor creates one, but independent equity investors and lenders fund it. Accounting rules decide whether it counts as separate from the sponsor, and Enron disclosed few details about its entities. It told shareholders that the entities hedged the downside risk of its illiquid investments. Investors did not know that the entities were financed with Enron's own stock and guarantees, which left Enron unprotected.

  One arrangement began in 1993, when Enron formed a joint venture in energy investments with CalPERS, the California state pension fund. It was called Joint Energy Development Investments, or JEDI. In 1997 Skilling, then chief operating officer, asked CalPERS to join Enron in a separate investment. CalPERS was interested only if it could leave JEDI. Enron did not want to book debt from buying out CalPERS's stake. Chief Financial Officer Andrew Fastow solved the problem with Chewco Investments, a limited partnership that raised debt guaranteed by Enron. Chewco bought the stake for $383 million, and JEDI's losses stayed off Enron's balance sheet. In autumn 2001 the arrangement came to light and Enron had to stop its accounting for Chewco and JEDI. Earnings from 1997 to mid-2001 had to be cut by $405 million, and indebtedness rose by $628 million.

  Whitewing Associates L.P. was formed in December 1997, with $579 million from Enron and $500 million from an outside investor. Two years later its terms were changed so that it would no longer be consolidated onto Enron's balance sheet. Whitewing then bought Enron assets, including stakes in power plants, pipelines and stocks. Between 1999 and 2001 those purchases totaled $2 billion, backed by Enron stock as collateral. Enron's board approved the transactions, but the transfers were not true sales and should have been treated as loans.

  In 1999 Fastow formed two partnerships, LJM Cayman L.P. and LJM2 Co-Investment L.P., known as LJM1 and LJM2. They served as the outside equity investor that Enron's special purpose entities needed. They also bought Enron's poorly performing stocks and stakes to improve its financial statements. Because Fastow was chief financial officer, he had to ask the board for an exemption from Enron's code of ethics so he could manage them. About $390 million in funding came from Wachovia, J.P. Morgan Chase, Credit Suisse First Boston, Citigroup and other investors. Merrill Lynch marketed the equity and put in $22 million itself.

  Four LJM-related entities, Raptor I through IV, were named after the velociraptors in Jurassic Park. Enron transferred to them more than $1.2 billion in assets, including millions of its own shares and rights to buy millions more, plus $150 million of its notes payable. Enron booked the notes as assets and raised shareholders' equity by the same amount. Undoing that treatment later cut net shareholders' equity by $1.2 billion.

  The Raptors also entered derivative contracts with Enron with a notional amount of $2.1 billion. The swaps were set when Enron's stock hit its peak. Over the following year the portfolio's value fell by $1.1 billion, meaning the entities technically owed Enron that sum. Using mark-to-market accounting, Enron claimed a $500 million gain on the swaps in its 2000 annual report. That gain offset stock portfolio losses and made up nearly a third of the year's earnings, until it was restated in 2001.

  How much Fastow himself earned from running the LJM partnerships would not come out until October 2001.

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• 5. Culture of Appearances

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  Stock tickers hung in Enron's lobbies and elevators and ran on its company computers. The pay system was meant to keep and reward valuable employees. Instead it fed a culture obsessed with short-term earnings, because bonuses followed them. Employees kept starting deals, often paying little attention to the quality of cash flow or profit, to earn better performance ratings. Results were booked as soon as possible to keep pace with the stock price. Deal-makers and executives collected large cash bonuses and stock options. Management pay leaned heavily on options, as at other American companies, which pushed leaders to promise rapid growth.

  At budget meetings, Skilling set target earnings by asking, "What earnings do you need to keep our stock price up?" That number was used even when it was not feasible. On the 31st of December 2000-96 million shares, about 13 percent of the common shares outstanding, were covered by stock option plans. At the January 2001 price of $83.13, the directors' stock ownership was worth $659 million for Lay and $174 million for Skilling.

  Spending was loose too. Skilling believed that constant worry about costs would hinder original thinking, so extravagance spread, especially among executives. Employees had large expense accounts, and some executives were paid twice what competitors offered. In 1998 the 200 highest-paid employees received $193 million in salaries, bonuses and stock. Two years later the figure was $1.4 billion.

  Appearances were managed as well. Enron habitually booked the costs of cancelled projects as assets, reasoning that no official letter had declared them cancelled. The practice was called "the snowball". At first it applied to projects worth less than $90 million, and later the limit rose to $200 million. In 1998, analysts toured the Enron Energy Services office and were impressed by how hard the staff worked. Skilling had moved in employees from other departments and told them to pretend. The ruse was reused several times to make different divisions look larger than they were.

  Azurix, a division preparing for a public stock offering, planned to bid between $321 million and $353 million for the rights to run water services around Buenos Aires. That sat at the high end of what Enron's Risk Assessment and Control Group advised. As the offering neared and the pressure to win grew, executives raised the bid to $438.6 million, about twice the next highest sealed bid. When Enron executives arrived at the Argentine facilities, they found them in shambles, with all customer records destroyed.

  Enron's directors and auditors were supposed to be the check on all of this.

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• 6. Boards and Auditors

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  In 2000 the magazine Chief Executive named Enron among the five best corporate boards. The board was made up mostly of outsiders with significant ownership stakes, backed by an audit committee with more expertise than most. Members included Robert K. Jaedicke, an accounting professor and former dean of the business school at Stanford, and Wendy Gramm, a former chair of the Commodity Futures Trading Commission. John Wakeham, a former United Kingdom Secretary of State for Energy, also sat on it.

  Yet the committee met briefly and covered large amounts of material. At one meeting, on the 12th of February 2001, it sat for an hour and a half. Members lacked the technical knowledge to question the auditors about the special purpose entities. Pressure also kept them from questioning management. A report from a United States Senate subcommittee accused board members of letting conflicts of interest get in the way of monitoring the company's accounting.

  The same subcommittee found that the board knew more than might be assumed. Directors were told the reasons for the Whitewing, LJM and Raptor transactions, approved them, and then received status updates. But the finance committee and the board lacked the experience with derivatives to grasp what they were told. The subcommittee argued that a detailed understanding would have led the board to prevent their use. Hedging risk with entities that Enron itself owned meant Enron kept the risk, in effect hedging with itself.

  Arthur Andersen, Enron's accounting firm, earned $25 million in audit fees from Enron during 2000. It earned another $27 million in consulting fees. Critics saw a conflict of interest that encouraged lax auditing. Others suspected that Andersen simply wanted its annual fees, or lacked the expertise to review revenue recognition, special entities and derivatives.

  Enron hired numerous certified public accountants, including people who had helped develop accounting rules at the Financial Accounting Standards Board. One Enron accountant later said: "We tried to aggressively use the literature GAAP to our advantage. All the rules create all these opportunities. We got to where we did because we exploited that weakness."

  Andersen's auditors came under pressure from management to postpone recognizing charges from the special purpose entities as their credit risks became known. Because the entities would never turn a profit, the rules called for a write-off. To keep Andersen in line, Enron sometimes let Ernst & Young or PricewaterhouseCoopers do accounting tasks, creating the illusion that a new firm might replace Andersen. Internal controls existed to guard against local partners' conflicted incentives, but they failed. Andersen's Houston office, which handled the Enron audit, could overrule critical reviews from a Chicago partner.

  The Powers Committee, appointed by Enron's board in October 2001, concluded that Andersen "did not fulfill its professional responsibilities". Outside the company, meanwhile, one regional newspaper story was about to catch a short seller's eye.

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• 7. The Unraveling

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  On the 20th of September 2000, a Wall Street Journal reporter in Dallas wrote about how common mark-to-market accounting had become in the energy industry. He noted that outsiders had no real way to know the assumptions behind the earnings of companies using it. The story ran only in the Journal's Texas edition, but the short seller Jim Chanos happened to read it. Chanos pulled Enron's annual 10-K report and found little that made sense. Its broadband unit seemed to outpace a troubled broadband industry, and the company was spending much of its invested capital. Insiders were also selling large amounts of stock. In November 2000 he decided to short Enron's shares.

  In February 2001, Chief Accounting Officer Rick Causey told budget managers, "From an accounting standpoint, this will be our easiest year ever. We've got 2001 in the bag." On the 5th of March, Fortune published Bethany McLean's article "Is Enron Overpriced?" It asked how the company could sustain a stock trading at 55 times earnings when analysts and investors did not know exactly how it made money. Chanos had suggested she read the 10-K herself. She later described finding "strange transactions", "erratic cash flow" and "huge debt". The debt was the biggest red flag, since a supposedly profitable company was adding it so fast. When she phoned Skilling before publication, he called her "unethical" for not researching his company properly.

  On the 17th of April 2001, on a recorded conference call, analyst Richard Grubman complained that Enron was the only company that could not release a balance sheet with its earnings. Skilling, by then chief executive, answered with a crude insult. Employees turned it into an inside joke at Grubman's expense.

  On the 14th of August, Skilling resigned as chief executive after only six months, citing personal reasons. Observers noted that in the preceding months he had sold at least 450,000 shares worth about $33 million, though he still held over a million. Lay, the chairman, told surprised market watchers there would be "no change in the performance or outlook of the company going forward". He then took the chief executive job back.

  The next day, Sherron Watkins, a vice president for corporate development, sent Lay an anonymous letter. "I am incredibly nervous that we will implode in a wave of accounting scandals," she wrote. On the 22nd of August she met him and handed over a six-page letter. Lay asked whether she had told anyone outside the company, and said he would have the law firm Vinson & Elkins review her concerns. Watkins warned that this was a conflict of interest. Executives wanted to dismiss her, since Texas law did not protect company whistleblowers, but decided against it to avoid a lawsuit. On the 15th of October, Vinson & Elkins announced that Enron had done nothing wrong, since Andersen had approved each issue.

  The next day, Enron announced it would restate its financial statements for 1997 through 2000. The restatements cut earnings by $613 million, or 23 percent of reported profits for the period. On the 22nd of October, Fastow told the board he had earned $30 million from managing the LJM partnerships. That same day the Securities and Exchange Commission announced it was investigating several deals, which it called "some of the most opaque transactions with insiders ever seen". Enron's shares fell $5.40 to $20.65.

  On the 25th of October, Fastow was removed as chief financial officer, only a day after Lay had expressed confidence in him. Several banks had refused to lend to Enron while he stayed. The stock was down to $16.41, half its value in a little more than a week. Jeff McMahon, head of industrial markets, took over and faced a cash crisis. Enron could no longer sell commercial paper, its short-term borrowing, even overnight. McMahon and a financial "SWAT team" found that Fastow had built off-balance-sheet vehicles while neglecting the basics. Enron operated only quarterly, with no procedures for tracking cash or debt maturities. In effect, it was illiquid. On the 27th of October, Enron began buying back all its commercial paper, about $3.3 billion, by drawing down its bank credit lines.

  On the 30th of October, Moody's lowered Enron's credit rating from Baa1 to Baa2, two levels above junk status. On the 2nd of November, rival Dynegy supplied $1 billion in new financing, secured by Enron's Northern Natural Gas and Transwestern Pipeline assets. By then the stock was around $7. Late on the 7th of November, Dynegy's board voted to acquire Enron for about $8 billion in stock. Chevron Texaco, which owned about a quarter of Dynegy, agreed to provide Enron with $2.5 billion in cash. Dynegy would also take on nearly $13 billion of debt. Enron shareholders would receive a 40 percent stake in the enlarged company.

  Employees paid the steepest price in the meantime. Lay stood to collect a $60 million change-of-control payment from the Dynegy deal, while workers' retirement accounts, heavy in Enron stock, had lost 90 percent in a year. An official at an Enron-owned company said, "We had some married couples who both worked who lost as much as $800,000 or $900,000."

  The deal did not hold. On the 19th of November, Enron disclosed debt repayment obligations of about $9 billion by the end of 2002, far beyond its available cash. Two days later a filing showed that nearly $5 billion it had recently borrowed was gone in just 50 days. Dynegy then demanded a price of $4 billion instead of $8 billion. On the 28th of November, all the credit rating agencies cut Enron to junk status. Dynegy's board rejected the merger on the advice of its chief executive, Charles Watson, who later said, "At the end, you couldn't give it Enron to me."

  Early estimates put the markets' exposure to Enron at $18.7 billion. Corporate treasurer Ray Bowen had known on the day Dynegy pulled out that bankruptcy was coming. He spent the next two days looking for a bank to take Enron's remaining cash after it pulled everything out of Citibank, and settled for a small Houston bank.

  On the 30th of November, Enron Europe, the holding company for its continental European operations, filed for bankruptcy. The rest of Enron followed the next night, when its board voted unanimously for Chapter 11 protection. With $63.4 billion in assets, it became the largest bankruptcy in U.S. history, passing the 1970 failure of Penn Central. WorldCom's bankruptcy the next year took the title. About 4,000 jobs were lost.

  On the 17th of January 2002, Enron dismissed Arthur Andersen as its auditor, citing its accounting advice and the destruction of documents.

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• 8. The Reckoning

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  Andrew Fastow was first charged with 98 counts of fraud, money laundering, insider trading and conspiracy, among other crimes. He pleaded guilty to two conspiracy charges and received ten years with no parole, in a plea bargain requiring him to testify against Lay, Skilling and Causey. His wife, Lea, was indicted on six felony counts, but prosecutors dropped those for a single misdemeanor tax charge. She was sentenced to one year for helping hide income from the government. Michael Kopper, who had worked at Enron for more than seven years, was the first Enron executive to plead guilty. Rick Causey was indicted on six felony counts for disguising Enron's financial condition. He first pleaded not guilty, later changed his plea, and received seven years.

  Lay and Skilling went on trial in January 2006 on a 53-count, 65-page indictment. Judge Sim Lake had refused their requests for separate trials and for moving the case out of Houston. On the 25th of May 2006, the jury returned its verdicts. Skilling was convicted on 19 of 28 counts of securities fraud and wire fraud and acquitted on the other nine, including insider trading. He received 24 years and 4 months, cut by ten years in a 2013 deal with the Justice Department. Lay was convicted on all six counts he faced, with a maximum total sentence of 45 years. He had claimed that others misled him and blamed Fastow. Lay died on the 5th of July 2006, before sentencing. The Securities and Exchange Commission had been seeking more than $90 million from him.

  Sixteen people pleaded guilty to crimes committed at the company, and five others were found guilty. Eight former executives testified against Lay and Skilling, with Fastow as the main witness. Kenneth Rice, former chief of the high-speed Internet unit, cooperated and received a 27-month sentence in June 2007. Michael W. Krautz, a former Enron accountant, was acquitted after a month-long jury trial.

  Four of the five were former Merrill Lynch employees, convicted in November 2004 for helping Enron with fraudulent accounting. The case centered on Nigerian barges that Merrill Lynch bought shortly before an earnings deadline, with an alleged buyback guarantee from Enron. The government said Enron misreported a bridge loan as a sale, then bought the barges back a few months later. In 2006, an appeals court in New Orleans called the charges "flawed" and threw them out, after the executives had spent nearly a year in prison. The Justice Department decided not to retry the case.

  Three British men who worked for Greenwich NatWest, Giles Darby, David Bermingham and Gary Mulgrew, had dealt with Fastow on a special purpose entity called Swap Sub. The United States issued arrest warrants in June 2002 on seven counts of wire fraud, and they were extradited. In November 2007 they pleaded guilty to one count, and each received 37 months in prison. In August 2010, Bermingham and Mulgrew retracted their confessions.

  The financial damage fell hardest on ordinary holders. Shareholders lost $74 billion in the four years before the bankruptcy, with $40 billion to $45 billion of that attributed to fraud. They received little compensation because nearly $67 billion was owed to creditors. To pay them, Enron was ordered to sell assets including art, photographs, logo signs and its pipelines. Nearly 62 percent of the savings plans of 15,000 employees relied on Enron stock bought at $83 in early 2001, which was now practically worthless. Some employees, such as John D. Arnold, received large bonuses in the company's last days.

  A class action for about 20,000 employees who alleged mismanagement of their 401(k) plans produced a $356 million settlement in July 2005 against Enron and plan manager Northern Trust. A year later it was reduced to $37.5 million in an agreement overseen by federal judge Melinda Harmon, with Northern Trust neither admitting nor denying wrongdoing.

  Commentators later disagreed about the causes. Ethical explanations stressed executive greed and hubris, a lack of corporate social responsibility, and get-it-done business pragmatism. Political-economic explanations pointed to deregulation since the 1970s and too little staff and funding for regulatory oversight. Congress responded with new regulations. The Sarbanes-Oxley Act raised penalties for destroying, altering or fabricating records in federal investigations, and for attempting to defraud shareholders. It also made auditing firms more accountable for staying unbiased and independent of their clients.

  Arthur Andersen was found guilty of obstruction of justice on the 15th of June 2002. After news of the SEC investigation, it had shredded several tons of documents and deleted nearly 30,000 emails and computer files. Nancy Temple of the legal department and David Duncan, lead partner on the Enron account, were named as the managers who ordered the shredding. Duncan pleaded guilty to obstruction of justice on the 10th of April 2002. Because the SEC may not accept audits from convicted felons, the firm was effectively put out of business, even though only a small number of its employees had been involved. It surrendered its CPA license on the 31st of August 2002, and 85,000 employees lost their jobs.

  The U.S. Supreme Court later overturned the conviction because the jury had not been properly instructed on the charge. In theory, that left Andersen free to resume operations. But the firm's name was so badly damaged, partly by accounting malpractice involving WorldCom, that it never returned as a viable business. In 2014, Wealth Tax and Advisory Services, a firm started by several former Andersen partners, acquired the rights to the Andersen name and became Andersen Tax. Its year-old international arm, previously called WTAS Global, was renamed Andersen Global.

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