Enron Scandal: The Fall of a Wall Street Darling By TROY SEGAL
Updated May 29, 2019
The story of Enron Corporation depicts a company that reached dramatic heights only to face a dizzying fall. The fated company's collapse affected thousands of employees and shook Wall Street to its core. At Enron's peak, its shares were worth $90.75; when the firm declared bankruptcy on December 2, 2001, they were trading at $0.26. To this day, many wonder how such a powerful business, at the time one of the largest companies in the United States, disintegrated almost overnight. Also difficult to fathom is how its leadership managed to fool regulators for so long with fake holdings and off-the-books accounting.
Why Enron Collapsed
Enron FY2000 Reported Revenue
Investopedia / Source Data: Forbes / Created using Datawrapper
Enron's Energy Origins
Enron was formed in 1985 following a merger between Houston Natural Gas Company and Omaha-based InterNorth Incorporated. Following the merger, Kenneth Lay, who had been the chief executive officer (CEO) of Houston Natural Gas, became Enron's CEO and chairman. Lay quickly rebranded Enron into an energy trader and supplier. Deregulation of the energy markets allowed companies to place bets on future prices, and Enron was poised to take advantage. In 1990, Lay created the Enron Finance Corporation and appointed Jeffrey Skilling, whose work as a McKinsey & Company consultant had impressed Lay, to head the new corporation. Skilling was then one of the youngest partners at McKinsey.
Skilling joined Enron at an auspicious time. The era's minimal regulatory environment allowed Enron to flourish. At the end of the 1990s, the dot-com bubble was in full swing, and the Nasdaq hit 5,000. Revolutionary internet stocks were being valued at preposterous levels and, consequently, most investors and regulators simply accepted spiking share prices as the new normal.
KEY TAKEAWAYS
Enron's leadership fooled regulators with fake holdings and off-the- books accounting practices.
Enron used special purpose vehicles (SPVs), or special purposes entities (SPEs), to hide its mountains of debt and toxic assets from investors and creditors.
The price of Enron's shares went from $90.75 at its peak to $0.26 at bankruptcy.
The company paid its creditors more than $21.7 billion from 2004 to 2011.
Mark-to-Market
One of Skilling's early contributions was to transition Enron's accounting from a traditional historical cost accounting method to mark-to- market (MTM) accounting method, for which the company received official SEC approval in 1992. MTM is a measure of the fair value of accounts that can change over time, such as assets and liabilities. Mark-to-market aims to provide a realistic appraisal of an institution's or company's current financial situation, and it is a legitimate and widely used practice. However, in some cases, the method can be manipulated, since MTM is not based on "actual" cost but on "fair value," which is harder to pin down. Some believe MTM was the beginning of the end for Enron as it essentially permitted the organization to log estimated profits as actual profits.
Enron Hailed for Its Innovation
Enron created Enron Online (EOL) in October 1999, an electronic trading website that focused on commodities. Enron was the counterparty to every transaction on EOL; it was either the buyer or the seller. To entice participants and trading partners, Enron offered its reputation, credit, and expertise in the energy sector. Enron was praised for its expansions and ambitious projects, and it was named "America's Most Innovative Company" by Fortune for six consecutive years between 1996 and 2001.
Blockbuster Video's Role
One of the many unwitting players in the Enron scandal was Blockbuster, the former juggernaut video rental chain. In July 2000, Enron Broadband Services and Blockbuster entered a partnership to enter the burgeoning VOD market. The VOD market was a sensible pick, but Enron started logging expected earnings based on the expected growth of the VOD market, which vastly inflated the numbers.
By mid-2000, EOL was executing nearly $350 billion in trades. When the dot-com bubble began to burst, Enron decided to build high-speed broadband telecom networks. Hundreds of millions of dollars were spent on this project, but the company ended up realizing almost no return.
When the recession hit in 2000, Enron had significant exposure to the most volatile parts of the market. As a result, many trusting investors and creditors found themselves on the losing end of a vanishing market cap.
The Wall Street Darling Crumbles
By the fall of 2000, Enron was starting to crumble under its own weight. CEO Jeffrey Skilling hid the financial losses of the trading business and other operations of the company using mark-to-market accounting. This technique measures the value of a security based on its current market value instead of its book value. This can work well when trading securities, but it can be disastrous for actual businesses.
In Enron's case, the company would build an asset, such as a power plant, and immediately claim the projected profit on its books, even though the company had not made one dime from the asset. If the revenue from the power plant was less than the projected amount, instead of taking the loss, the company would then transfer the asset to an off-the-books corporation where the loss would go unreported. This type of accounting enabled Enron to write off unprofitable activities without hurting its bottom line.
The mark-to-market practice led to schemes that were designed to hide the losses and make the company appear more profitable than it really was. To cope with the mounting liabilities, Andrew Fastow, a rising star who was promoted to chief financial officer in 1998, developed a deliberate plan to show that the company was in sound financial shape despite the fact that many of its subsidiaries were losing money.
Enron Timeline
Investopedia
How Did Enron Hide Its Debt?
Fastow and others at Enron orchestrated a scheme to use off-balance-sheet special purpose vehicles (SPVs), also known as special purposes entities (SPEs), to hide its mountains of debt and toxic assets from investors and creditors. The primary aim of these SPVs was to hide accounting realities rather than operating results.
The standard Enron-to-SPV transaction would be the following: Enron would transfer some of its rapidly rising stock to the SPV in exchange for cash or a note. The SPV would subsequently use the stock to hedge an asset listed on Enron's balance sheet. In turn, Enron would guarantee the SPV's value to reduce apparent counterparty risk.
SPV Loophole
Investopedia
Although their aim was to hide accounting realities, the SPVs were not illegal. But they were different from standard debt securitization in several significant—and potentially disastrous— ways. One major difference was that the SPVs were capitalized entirely with Enron stock. This directly compromised the ability of the SPVs to hedge if Enron's share prices fell. Just as dangerous as the second significant difference: Enron's failure to disclose conflicts of interest. Enron disclosed the SPVs' existence to the investing public—although it's certainly likely that few people understood them—it failed to adequately disclose the non-arm's- length deals between the company and the SPVs.
Enron believed that their stock price would continue to appreciate—a belief similar to that embodied by Long -Term Capital Management, a large hedge fund, before its collapse in 1998. Eventually, Enron's stock declined. The values of the SPVs also fell, forcing Enron's guarantees to take effect.
Arthur Andersen and Enron
In addition to Andrew Fastow, a major player in the Enron scandal was Enron's accounting firm Arthur Andersen LLP and partner David B. Duncan, who oversaw Enron's accounts. As one of the five largest accounting firms in the United States at the time, Andersen had a reputation for high standards and quality risk management.
However, despite Enron's poor accounting practices, Arthur Andersen offered its stamp of approval, signing off on the corporate reports for years. By April 2001, many analysts started to question Enron's earnings and the company's transpa rency.
The Shock Felt Around Wall Street
By the summer of 2001, Enron was in freefall. CEO Kenneth Lay had retired in February, turning over the position to Jeffrey Skilling. In August 2001, Skilling resigned as CEO citing personal reasons. Around the same time, analysts began to downgrade their rating for Enron's stock, and the stock descended to a 52-week low of $39.95. By October 16, the company reported its first quarterly loss and closed its "Raptor" SPV so that it would not have to distribute 58 million shares of stock, which would further reduce earnings. This action caught the attention of the SEC.
A few days later, Enron changed pension plan administrators, essentially forbidding employees from selling their shares for at least 30 days. Shortly after, the SEC announced it was investigating Enron and the SPVs created by Fastow. Fastow was fired from the company that day. Also, the company restated earnings going back to 1997. Enron had losses of $591 million and had $628 million in debt by the end of 2000. The final blow was dealt when Dynegy (NYSE: DYN), a company that had previously announced would merge with Enron, backed out of the deal on November 28. By December 2, 2001, Enron had filed for bankruptcy.
$74 billion
The amount that shareholders lost in the four years leading up to Enron's bankruptcy.
Bankruptcy
Once Enron's Plan of Reorganization was approved by the U.S. Bankruptcy Court, the new boa rd of directors changed Enron's name to Enron Creditors Recovery Corporation (ECRC). The company's new sole mission was "to reorganize and liquidate certain of the operations and assets of the 'pre-bankruptcy' Enron for the benefit of creditors." The company paid its creditors more than $21.7 billion from 2004 to 2011. Its last payout was in May 2011.
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Poster Comment:
This is a blast from the past and underscores how things can get out of hand quickly.
The Enron scandal changed reporting requirements for all companies traded on the stock exchanges.