The Enron Scandal and Securities-Law Reform
Enron. WorldCom. Tyco. Adelphia. These companies have come to represent a wave of corporate scandal that plagued America in the early 2000s. Each company engaged in varying levels of mismanagement, questionable financial deals, and accounting fraud. The activities at these companies shook investor confidence in U.S. corporations. They also tarnished the reputations of financial services professionals such as analysts, accountants, and auditors. Consider the following:
- Once called the “Most Innovative Company in America,” energy company Enron filed for bankruptcy in December 2001. It used several different fraudulent accounting methods to hide billions of dollars of debt from its investors and lenders.
- Cable company Adelphia filed for bankruptcy in June 2002. In 2004, a federal jury convicted Adelphia’s founder of bank and securities fraud. He was sentenced to 15 years in prison.
- Telecommunications company WorldCom filed for bankruptcy in July 2002. At the time, it was the largest bankruptcy in U.S. history. In July 2005, a federal court sentenced the chief executive officer (CEO) of WorldCom to 25 years in prison for corporate fraud.
- In June 2005, a jury convicted a former Tyco CEO of theft, conspiracy, securities fraud, and falsifying business records. A court in New York sentenced him to between 8 and 25 years in prison. He was ordered to pay restitution and fines of more than $200 million.
The financial mismanagement at these companies contributed to the largest reform in U.S. securities laws since the Great Depression. The Enron bankruptcy is the case that spurred Congress to act. It is important to understand the Enron scandal to appreciate how significant the reform was.
Corporate Fraud at Enron
The Enron case has become a part of American pop culture, as its name is now synonymous with corporate greed and scandal. Nearly 20 years after the scandal, it continues to hold our attention.
Enron, which was based in Houston, Texas, formed in 1985 through the merger of two natural gas companies. Kenneth Lay was the CEO of the company. By the mid-1990s, Enron was the leading U.S. natural gas company.
Public Versus Private Companies
A public company is also called a publicly traded company. Many investors own a public company, in which investors own a portion of the company in the form of stock. A stock represents a share of a corporation’s profits or assets. A person’s percentage of ownership in the corporation depends on how many shares of stock he or she owns.
Shareholders are entitled to portions of a public company’s profits. Their share, called a dividend, represents each shareholder’s portion of the company’s earnings. People who own more shares of stock receive larger dividends.
Public corporations are allowed to sell stocks and bonds. A bond represents a loan to the corporation for a specified period. The corporation must pay bondholders back the full value of the bond, plus interest. However, a person who owns a corporate bond does not have any ownership in a corporation. Only stocks represent an ownership interest. Stocks and bonds together are called securities.
In the United States, the stock of a public company is traded on a stock exchange. The two most popular U.S. stock exchanges are the New York Stock Exchange (NYSE) and the NASDAQ Stock Market. National securities exchanges are registered with the U.S. Securities and Exchange Commission (SEC). You can learn more at https://www.sec.gov/fast-answers/divisionsmarketregmrexchangesshtml.html.
Almost all securities sold in the United States must be registered with the SEC. To register its securities, a company must file documents about its financial condition with the SEC on a regular basis. Investors review these documents to make informed investment decisions.
A public company is different from a privately held company, in which a small group of private investors owns a privately held company. In some cases, the investors all might be members of the same family. A private company does not have to answer to shareholders in the same way that a public company does. A private company distributes its profits to its owners.
Private companies do not have to register with the SEC. They also do not have to file documents with the SEC that show their financial position. The largest private companies in the United States include Cargill, Koch Industries, and Albertsons.1
Enron grew quickly because it took advantage of energy market deregulation in the late 1980s. It bought and sold gas and electricity through futures contracts. These investments were initially very successful. As it grew, Enron expanded into other markets. It purchased steel mills, water utilities, and even tried to enter the internet broadband market. It also expanded internationally, pursuing opportunities in England, Mexico, and India.
From 1997 to 2001, Fortune magazine put Enron on its “Most Innovative Companies in America” list.2 In 2000, it named Enron to its “World’s Most Admired Companies” list.3 Enron grew from 7,500 employees in 1996 to more than 20,000 employees in 2001. Its stock was valuable. Enron encouraged its employees to include Enron stock in their retirement portfolios.
To the outside world, Enron was a very successful company. Its required filings with the U.S. SEC showed that it was making money. It appeared to be able to translate its success in the energy markets to other markets. Financial analysts continued to recommend Enron stock. Investors continued to buy it.
In reality, Enron was struggling. It lost billions of dollars on its international investments. Enron also started to face increased competition in the energy business. It began to lose its market share in energy futures contracts because other energy companies started to use Enron’s own strategies to become profitable.
By the late 1990s, Enron was in financial trouble and needed to raise money to meet its operating expenses. However, it did not want to do this in a way that would alarm its investors or alert them to potential trouble, which could cause its stock price to fall. Maintaining a high stock price was important to bring in new investors. It also was critical to being able to maintain credit lines with banks.
FYI
A futures contract is a contract for the sale of a good. One party agrees to sell the other party an asset at some point in the future. The two parties agree on the future quantity and price for the asset at the time the contract is made. Companies use futures contracts as an investment tool rather than as an actual contract to supply goods.
Enron executives engaged in several complicated financial transactions to hide its losses. Its chief financial officer (CFO), Andrew Fastow, created several affiliated companies, then hid Enron’s losses in the financial records of these companies. The Enron CFO and other employees who worked with him owned many of these affiliated companies and profited from the transactions between Enron and the affiliated companies.
These transactions were very complex and complicated to understand because Enron often changed the names of its different divisions. It also moved assets back and forth between divisions. Many of these transactions violated traditional accounting principles, which are called generally accepted accounting principles (GAAP). They are the rules for the accounting process. Accountants prepare financial statements according to these rules, which are designed to promote accurate accounting records.
Enron also mislabeled loans that it received from banks to hide the transactions on its own financial statements so that its investors would not know about them. By some reports, Enron borrowed about $8.6 billion from 1992 to 2001.4 However, it hid these loans from its investors. During this time, Enron filed earnings statements with the SEC that misstated its financial position. The SEC filings were hard to understand. They also showed that Enron appeared to be making money.
In February 2001, CEO Kenneth Lay retired. The new CEO, Jeffrey Skilling, had been instrumental in taking Enron into new trading markets in the 1990s. He and CFO Andrew Fastow oversaw most of Enron’s business practices.
In April 2001, many financial analysts began to question Enron’s complicated financial statements.5 Enron, however, continued to portray the image of a successful company. Jeffrey Skilling unexpectedly resigned from the CEO post in August 2001, at which time the board of directors asked Kenneth Lay to return to Enron as its CEO, which he did.
In October 2001, Enron announced its first ever loss. The SEC noticed this announcement and began to review Enron’s financial statements. Enron also began its own investigation. In late October, the Enron board of directors established a special committee, led by Director William C. Powers, to investigate the affiliated companies created by Fastow. The report that the committee issued is known as the “Powers Report.”6
In November 2001, Enron announced that it was amending its 1997–2001 financial statements because of accounting errors. This announcement shook investor confidence in Enron, and its stock price began to drop. Banks would no longer issue it credit to meet its operating expenses. At the end of November 2001, Enron stock was worth less than a dollar per share.7
FYI
The Powers Report, released in February 2002, noted that Enron’s executive officers mismanaged many aspects of the company’s business. It also placed blame on Enron’s Board of Directors for failing in its corporate oversight duties. It blamed Enron’s accounting advisor, Arthur Andersen, for failing to provide objective accounting advice. You can read a copy of the report at http://i.cnn.net/cnn/2002/LAW/02/02/enron.report/powers.report.pdf.
On December 2, 2001, Enron filed for bankruptcy. At the time, it was the largest bankruptcy ever. In January 2002, Enron removed its stock from the New York Stock Exchange (NYSE).8
The fallout from the Enron case was enormous. Employees who had invested their retirement savings in Enron stock lost $1.3 billion.9 The accounting firm Arthur Andersen, Enron’s auditor, closed down. The U.S. government prosecuted many of Enron’s top executives for their involvement in its business dealings. Some of these prosecutions were difficult because it was hard to determine which executives were involved in the fraud, and which executives were not. The complexity of Enron’s financial dealings contributed to this difficulty.
CFO Andrew Fastow entered into a plea agreement with the U.S. government. He agreed to testify against Jeffrey Skilling and Kenneth Lay in exchange for a sentence of no more than 10 years in prison. In September 2006, a federal court sentenced him to 6 years in prison. He also paid more than $30 million in restitution. Fastow was released from prison in December 2011.
Enron founder and CEO Kenneth Lay was convicted in May 2006 for fraud and conspiracy. He died of a heart attack in July 2006. The court vacated his conviction after his death because he died before he could appeal.
Former CEO Jeffrey Skilling was convicted in 2006 on federal fraud charges. A federal court sentenced him to 24 years in prison. He appealed his conviction to the U.S. Supreme Court, which heard oral arguments in March 2010. On June 24, 2010, the U.S. Supreme Court ruled that the government had improperly applied a law used to convict Skilling and sent the case back to a lower court. In June 2013, Skilling was sentenced to 14 years in prison. He was released from jail in 2019.10