The Enron Scandal: What Happened?

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The Enron scandal was the collapse of a Houston energy and trading company that used aggressive accounting to report profits it had not earned and to keep large debts off its balance sheet. When falling share prices exposed those arrangements in late 2001, the company restated years of earnings, lost the confidence of its trading partners, and filed for bankruptcy on December 2, 2001. Its stock, which had peaked at $90.75, traded at $0.26 at the time of the filing. More than 20,000 employees were affected, shareholders lost about $74 billion in the four years before the bankruptcy, and Congress responded with the Sarbanes-Oxley Act of 2002.

From Pipeline Company to Trading House

Enron was formed in 1985 through the merger of Houston Natural Gas and InterNorth, a pipeline company based in Omaha, Nebraska. Kenneth Lay, the chief executive of Houston Natural Gas, became chairman and CEO of the combined company.

The timing mattered. Deregulation of U.S. natural gas and electricity markets was turning energy into something that could be traded like a financial product, and Enron set out to be the market maker in that business. In 1990 Lay created Enron Finance and hired Jeffrey Skilling, a consultant, to run it. Skilling argued that Enron did not need to own as many physical assets as a traditional utility. It could make money by standing between producers and buyers, writing contracts and managing price risk. That model needed a matching accounting method, and Skilling pushed for one.

How Mark-to-Market Accounting Inflated Enron’s Profits

Under historical cost accounting, a company records assets at what it paid for them and recognizes revenue as it is earned over time. Under mark-to-market accounting, assets and liabilities are carried at their current fair value, and changes in that value flow through earnings. The SEC approved Enron’s use of MTM in 1992.

MTM is a legitimate method, widely used for securities that trade in liquid markets, where fair value can be read off a screen. The problem at Enron was that many of its contracts ran for years or decades and had no active market. Fair value had to be estimated with internal models, and the people building the models were the same people paid on the results.

A hypothetical example shows the mechanics. Suppose a trading company signs a 10-year contract to supply energy and its model projects $10 million of profit per year. Under historical cost accounting, roughly $10 million would show up each year as the contract performs. Under MTM, the company can estimate the present value of all ten years of expected profit, say $70 million after discounting, and report it in the quarter the contract is signed. No cash has arrived yet. If prices, demand or costs later move against the contract, the estimate has to be marked down and the loss recognized.

Enron used this approach to report projected profits before they were realized, so reported income increasingly diverged from cash coming in. When deals underperformed, Enron did not write them down. It moved the losses out of its reported statements through the structures described below, which delayed recognition of its mounting liabilities.

EnronOnline, Broadband and the Bubble Years

Enron’s expansion happened during the dotcom bubble, when the Nasdaq passed 5,000 and many investors and regulators treated soaring share prices as normal. Enron wanted to be valued as a technology company, not a pipeline operator.

In October 1999 it launched EnronOnline, an electronic platform for trading commodities. Enron was the counterparty on every trade, so the platform’s appeal rested on Enron’s credit rating and reputation. By mid-2000 EnronOnline was executing nearly $350 billion in trades. That dependence on counterparty trust became a fatal weakness: once traders doubted Enron’s credit, they stopped dealing with it, and the core business stalled. The Commodity Futures Trading Commission later charged Enron with price manipulation and other illegal acts connected to its trading.

In July 2000, Enron Broadband Services announced a video-on-demand partnership with Blockbuster. Enron began recording expected earnings based on estimated growth of the VOD market, which vastly inflated the numbers for a business that was barely operating. As the dotcom bubble deflated, Enron kept investing in high-speed broadband networks, adding exposure to one of the weakest parts of the market just as the 2000 to 2001 downturn arrived.

Enron’s SPVs: How the Debt Was Hidden

As the gap between reported profits and real performance grew, Andrew Fastow, chief financial officer from 1998, built a system to keep Enron looking financially healthy even though many subsidiaries were losing money. The main tool was the special purpose vehicle, also called a special purpose entity.

An SPV is a separate legal entity created for a specific purpose, such as holding assets or financing a project. Companies use them routinely, for example in securitizing loans. Under the accounting rules of that era, a sponsoring company could keep an SPV off its own balance sheet if an independent outside party held at least 3% of the SPV’s equity and bore real risk. That treatment is what allowed Enron to move assets and the debt attached to them out of its consolidated financial statements.

Enron’s SPVs differed from ordinary securitizations in several ways:

• They were funded with Enron stock. Many vehicles, including the four known as the Raptors, were capitalized largely with Enron shares or rights to them. They were used to “hedge” losses on Enron’s investments, so Enron could avoid reporting declines in value. But a hedge backed by your own stock protects you only while your stock price holds up.
• The counterparties were not independent. Partnerships such as LJM1 and LJM2 were managed by Fastow himself, who earned fees and investment returns from deals with the company he served as CFO. Another entity, Chewco, was run by a Fastow subordinate. Enron disclosed that the partnerships existed but did not adequately disclose the non-arm’s-length nature of the deals.
• Outside equity was often inadequate. Where the required independent 3% stake was missing or was effectively guaranteed by Enron, the SPV should have been consolidated, bringing its debt back onto Enron’s books.

The circular structure worked in a rising market. When Enron’s share price fell in 2001, the SPVs no longer had enough value to absorb the losses they were supposed to cover, and the hidden liabilities came back to Enron.

Who Was Supposed to Be Watching

Enron’s auditor was Arthur Andersen LLP, then one of the five largest accounting firms in the United States. Andersen approved Enron’s financial reports despite the problems in its accounting, and its lead partner on the account, David B. Duncan, became a central figure in the investigation. Andersen also earned substantial consulting fees from Enron, raising questions about whether an auditor paid for other services can stay independent.

Enron’s board of directors approved waivers of the company’s conflict-of-interest code that allowed Fastow to run the partnerships. Wall Street analysts, many of whom kept positive ratings on the stock until late in 2001, and credit rating agencies also came under scrutiny for failing to warn investors in time.

How the Collapse Unfolded in 2001

By April 2001, a growing number of analysts were questioning Enron’s earnings and how little detail it disclosed. The decline then moved quickly:

1. February 2001: Lay stepped down as CEO and handed the role to Skilling, while remaining chairman.
2. August 2001: Skilling resigned after only months as CEO, citing personal reasons, and Lay returned as CEO. Analysts downgraded the stock, and it fell to a 52-week low of $39.95. The same month, vice president Sherron Watkins sent Lay a memo warning that the company could implode in a wave of accounting scandals.
3. October 16, 2001: Enron reported its first quarterly loss and closed the Raptor SPVs, which drew the SEC’s attention.
4. Days later: Enron changed the administrators of its employee retirement plan, locking employees out of selling Enron shares in their accounts for at least 30 days while the price kept falling.
5. Late October 2001: The SEC announced an investigation into Enron and Fastow’s partnerships. Fastow was removed as CFO.
6. November 2001: Enron restated its earnings back to 1997, revealing $591 million in losses and $690 million in debt by the end of 2000 that its earlier statements had not shown.
7. November 28, 2001: Dynegy, a rival that had agreed to merge with Enron, backed out of the deal. Credit agencies cut Enron’s debt to junk status.
8. December 2, 2001: Enron filed for Chapter 11 bankruptcy protection.

Employees were hit twice. They lost their jobs, and many had concentrated their retirement savings in Enron stock, so they lost billions in pension and retirement value at the same time.

Criminal Charges Against Enron’s Executives and Auditor

The Justice Department formed an Enron Task Force, and the prosecutions stretched over several years:

• Arthur Andersen was found guilty in June 2002 of obstructing justice by shredding Enron-related documents. The Supreme Court overturned the conviction in 2005 (Arthur Andersen LLP v. United States) because of flawed jury instructions, but by then the firm had surrendered its licenses to audit public companies and shrunk to a shell.
• Andrew Fastow pleaded guilty in 2004 to two counts of conspiracy related to wire fraud and securities fraud. In exchange for cooperating, he received a six-year sentence and was released in 2011.
• Kenneth Lay was convicted in May 2006 on six counts of fraud and conspiracy and, in a separate trial, four counts of bank fraud. He died of a heart attack in July 2006 before sentencing, and his convictions were vacated because he could not appeal.
• Jeffrey Skilling received the harshest sentence. Convicted in 2006 of conspiracy, securities fraud and insider trading, he was sentenced to more than 24 years. A 2013 agreement with prosecutors cut it to 14 years, sent about $42 million to fraud victims and ended his challenges to the conviction. He was released in February 2019.

Bankruptcy and Creditor Recovery

Under the reorganization plan approved by the U.S. Bankruptcy Court, the company was renamed Enron Creditors Recovery Corp. and given one mission: liquidate the remaining operations and assets of the pre-bankruptcy Enron for creditors. Between 2004 and 2012 it paid creditors more than $21.8 billion, raised from asset sales and from legal settlements with banks that had helped structure Enron’s deals. The last operating business, Prisma Energy, was sold in 2006. Shareholders, who rank behind creditors, were largely wiped out.

Sarbanes-Oxley and Other Reforms After Enron

Enron, followed in 2002 by the even larger collapse of WorldCom, led to the most significant overhaul of U.S. corporate reporting rules since the 1930s. President George W. Bush signed the Sarbanes-Oxley Act into law in July 2002. Its main provisions include:

• Executive certification: CEOs and CFOs must personally certify the accuracy of their company’s financial reports, with criminal penalties for knowingly false certifications.
• Internal controls: Management must assess and report on the company’s internal controls over financial reporting, and auditors of larger companies must attest to that assessment.
• Auditor oversight and independence: The act created the Public Company Accounting Oversight Board to regulate auditors of public companies and restricted the non-audit services an auditor can sell to an audit client.
• Tougher penalties: Destroying, altering or fabricating records to obstruct an investigation, and defrauding shareholders, carry heavier criminal consequences.

Exchange listing standards also changed, requiring more independent directors and independent audit committees responsible for hiring and supervising the auditor. Accounting standard setters later tightened the rules for consolidating special purpose entities, closing the off-balance-sheet route Enron had relied on.

Who Saw It Coming

Jim Chanos, a short seller at Kynikos Associates, became interested in Enron in October 2000 after a Wall Street Journal article noted that energy trading firms used “gain-on-sale” accounting for long-term trades, a method that can create earnings out of thin air under favorable assumptions. Studying Enron’s filings, Chanos concluded that its return on invested capital was below its cost of capital: the business was destroying value while reporting growth. His firm shorted Enron in November 2000 and earned hundreds of millions of dollars when the company failed.

Sherron Watkins, the vice president who wrote the August 2001 memo, became the best-known insider to raise the alarm. She testified before Congress and was named one of Time’s three Persons of the Year for 2002, alongside two other whistleblowers.

FAQs

The Bottom Line

Enron matters to investors, employees and anyone who relies on audited financial statements. Its collapse showed that reported profits can drift far from cash when fair values come from internal models, and that hedges or partnerships tied to a company's own stock fail once the share price drops. Employees who held retirement savings in Enron shares lost their jobs and their savings together, a direct cost of concentrating both in one employer.