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15 Facts about the Enron Scandal

Enron Head Quarters in Downtown Houston. Photo by Alex.

The Enron scandal was one of the most publicized scandal in the corporate world.
It was an accounting scandal involving Enron Corporation, an American energy company based in Houston, Texas, that was publicized after its discovery in October 2001.
The scandal was discovered when the company that had been doing so well for over twenty-five years declared losses and went into bankruptcy after state inspectors reviewed its books.
Enron was founded by an energy economist Kenneth Lay in 1985 through a merger of Houston Natural Gas and Inter North.
The company business was not doing well initially when he acquired it and he therefore hired McKinsey & Company to set new businesses model for the company. Kenneth Lay was impressed by the output of one the consultants, Jeffrey Skilling and hired him as the CEO.
Jeffrey Skilling being a seasoned consultant turned the business around and hired Andrew Faston as Chief Financial Officer who brought in the much needed finance expertise .
He brought in his creative accounting philosophy that eventually misled Enron’s board of directors and audit committee on high-risk accounting practices and pressured Arthur Andersen to ignore the issues they had raised on his practices.

In 1987 the first signs of fraudulent schemes were brought to the attention of Kenneth lay by a whistle blower and an investigation was carried out. It emerged that the Oil division president Louis Borget and Enron Oil’s treasurer, Thomas Mastroeni,  had fraudulently used the company resources including betting on oil prices, paying   luxurious personal expenses using the company money, these scheme came to be referred as the Valhalla Scandal. However the wrongdoings were unpunished since the two were making good  money for the company.

The company main goal shifted to expansion by altering its procedures and made investments in a variety of industries, including the internet, power generation, and trading. In some of these ventures it made a great leap such as the dot.com boom in the internet business while others started to fail.
The company began to suffer significant losses that  if disclosed on the company’s actual balance sheets  they would severe the company’s’ reputation.

To conceal this Fastow the Chief Finance Officer came up with a way to fake corporate growth where he created hundreds of companies to hide Enron’s US dollar 30 billion debt and changed the asset accounting method from historical cost method to mark to market (MM).

This change would see the company profitability increase and eventually overestimate their current assets. Further  to this they also added deals and unfinished projects to profit and loss statements leading to fictitious profits.

This pushed the  company’s  price to earning  ratio  to a high 60 which was way higher than the industry benchmarks of 20, this raised red flags but the company refused to  engage anyone who brought up this topic.

As a consequence of the scandal, new regulations and legislation were enacted to expand the accuracy of financial reporting for public companies. One piece of legislation, the Sarbanes–Oxley Act, increased penalties for destroying, altering, or fabricating records in federal investigations or for attempting to defraud shareholders. The act also increased the accountability of auditing firms to remain unbiased and independent of their clients

1.It was Formed via a Merger of two Companies in 1985

Enron was formed in 1985 by Kenneth Lay through a merger of  Houston Natural Gas and Inter North. Kenneth Lay was an experienced economist who had acquired a doctorate in economics from Houston University and had served at the Energy sector for more than a decade.

He later hired  Jeffrey Skilling, a Mc Kinsey bled executive as the chief executive officer, who brought on board quite a number of professionals to the business among them, Andrew Fastow the Chief Finance Officer famed for masterminding the Enron Scandal through his creative accounting philosophy.

2.Jeffrey Skilling at First Came in as McKinsey Consultant

Jeffrey Skilling The Mc Kinsey Employee Hired as CEO. Photo by United States Marshals Service.

The company initially didn’t do well l and wasn’t very profitable, so Lay hired McKinsey  to help them start new businesses. McKinsey deployed a consultant Jeffrey Skilling for this project, and Enron liked him so much that they hired him permanently. From there, the company began to perform well. Skilling then hired Andrew Fastow, who shared his philosophy and was known for complicating things.

A 2002 independent review described how executives stole millions from intricate, off-the-books agreements while giving shareholders false earnings reports.

Skilling was later convicted of 12 counts of securities fraud, five counts of making false statements to auditors, one count of insider trading and one count of conspiracy in 2006 for his role in hiding debt and orchestrating a web of financial fraud that ended in the Houston company’s bankruptcy.

3.The Valhalla Scandal in 1987 was the Predecessor to the Main Scandal

The first Enron scandal was the 1987 Valhalla Scandal beginning, which involved two oil traders, Louis Borget, Enron Oil’s president, and Thomas Mastroeni, Enron Oil’s treasurer. They would bet on whether the price of oil would rise or fall and were always accurate in their prediction, which was suspicious because nobody is always correct. They also set up offshore accounts and kept two sets of books, so they could falsely show that the oil division was making a profit year after year. Nobody was able to figure out who owned the offshore accounts. After the board received an anonymous tip that Borget embezzled more than $3 million and deposited it into his personal bank account, auditors were brought in and notified Kenneth Lay of Borget and Mastroeni’s fraudulent schemes. Because these two traders were making Enron so much money, Lay did nothing about it.

4. It Made a Leap During the Dotcom Boom

During the Dotcom Boom, when all businesses related to the internet were overvalued, Enron managed to manipulate accounts at some point and make enough money as a result of the boom since it was too closely associated with internet service providers and other similar businesses at the time. As soon as the Dotcom Bubble burst, all the firms started to decline, investors started selling their stocks out of fear, and bears quickly took control of the stock market.

5. Enron Experimented Investing in Difficult and Dangerous Industries.

The company  at one point shifted its main goal to expansion by altering its procedures and made investments in a variety of industries, including the internet, power generation, and trading.

However over time these all started to fail and the company began to suffer significant losses that were not disclosed on the company’s actual balance sheets to preserve its reputation.

They came up with it as a way to fake corporate growth, which can be easily done by manipulating company accounts.

It Started when Fastow created hundreds of companies to hide Enron’s $30 billion debt so it would appear as if Enron was more profitable than it actually was. Lou Pai was the CEO of Enron Energy Services.

He charged personal expenses, including strippers, to Enron’s expense account and used the corporate jet for personal use. Although he made $100 million while at Enron and around $250 million from selling stocks when he left Enron in 2001, his division had lost almost $1 billion. This loss was hidden using mark to market accounting.

6. Enron Employed M2M Accounting Method

The company wanted to change its accounting method from History Cost Accounting Method in which depreciation and incremental cost  are taken into consideration to Mark to market (M2M method) to method they overestimated their current assets and showed annual increases, valued assets with zero values extremely high, displayed and reported fictitious profits and sales, and added deals and unfinished projects to P&L statements. As a result, the company appeared to have expanded significantly, and Enron was recognized as one of the most innovative businesses in the US and received numerous awards.

In 2001 the energy division lost almost $1 billion. This loss was hidden using mark to market accounting. He also used mark to market accounting to value current energy prices based on expected future prices

7. Enron Used Special Purpose Vehicles  to Conceal Losses

Enron had declared fictitious profit over time and the company had no real money, therefore they had to devise a way to raise money.

To do this they started  special purpose vehicles  as a technique, which is a common business model used by large corporations  to test  new products on the market but are uncertain of its success. They do it via some small subsidiaries that are owned by them only, this ensures that if the product or idea fails, the failure has no bearing on the operation of the entire original corporation this protects the brand.

Enron would created a lot of these special purpose vehicles and  would sell them various  assets that way  their earnings on sell of assets increased. However these transactions were not supported by an actual cashflow meaning they were still financed by Enron to help declare paper profit.

These special purpose vehicles would then be used to obtain bank loans, which would be used to bank roll activities in the mother company.

8.Enron Manipulated the Energy  Makert Forces

Enron ensured that they manipulated the price of gas through the entire makert by creating speculative  demand  for instance Tim Belden, who ran Enron’s west coast’s trading desk would take advantage of California’s deregulated energy market.

Where he would create artificial shortages of energy by creating blackouts throughout California, which through the principles of supply and demand, would increase energy prices.

He even devised a plan where Enron would export California’s energy to another state and then buy it back at inflated prices to drive up the price of energy sold to California residents.

9.Enron Management was not Willing to Discuss its Financials

Despite  Enron trading  at a 60 price to earnings ratio, which was more than three times higher than other companies in its industry. The management was not willing to discuss and fully explain its finances.

10.Kenneth Lay Sold His Stocks to Employees 

Kenneth Lay  founder and chairman when he realized that the company was failing, he sold his stock while at the same time told his employees to purchase more. While Enron’s stock was plummeting before it declared bankruptcy on December 2, 2001, the top executives were able to sell shares worth Us Dollar 1 billion in stocks, while the employees’ stocks were frozen so they could not sell them. Later, the employees brought a class action case and were awarded an US Dollars 85 million settlement.

11. Enron Claimed a Loss of Almost USD 700 Million at its Bankruptcy

In 2001 when government inspectors were investigating the company it was  found to be quite strange for such a large corporation to have such significant losses all of a sudden, especially when government agencies conducted inspections and the scandal was made public.

12.Sherron Watkins was the First Whistle Blower

In August 2001, Watkins alerted Lay of accounting irregularities in financial reports. However, Watkins has been criticized for not reporting the fraud to government authorities and not speaking up publicly sooner about her concerns, as her memo did not reach the public until five months after it was written.

13.It led to Closure of Arthur Andersen

It is remembered in history as one of the cases of Audit failure and has been used in trainings.

Due to the Magnitude of the Loss ,Arthur Andersen, one of the five largest audit and accountancy partnerships in the world was effectively dissolved.

14.Top executives; Kenneth Lay and Jeffrey Skilling were charged with Fraud.

Kenneth Lay the Founder of Enron. Photo by United States Marshals Service.

The main perpetrators in Enron’s fraud scheme were Kenneth Lay, Jeffrey Skilling, Andy Fastow, Louis Borget, Thomas Mastroeni, Lou Pai, and Tim Belden.

In addition, the accounting firm Arthur Anderson, the law firm Vinson and Elkins, and various banks were also involved.

15.The Failure Led to  Enactment of The Sarbanes Oxley Act of 2002

Paul Sarbanes and Michael G. Oxley the Senator and Representative respectively , the two minds Behind Developing the Act. Photo by Adam SK.

The Enron scandal  shocked the financial sector in a way that had not been anticipated therefore the United States Senate and house of commons  led by   Senator Paul Sarbanes and  House of Common representative Michael G. Oxley  proposed a  a legislation that  would prevent similar frauds.

The Sarbanes Oxley Act of 2002 named after the two proponents  was passed in response to Enron various  accounting scandals and the failure by Arthur Anderson to query the same.

The act sought to set new auditing standards and protection for whistleblowers and internal control requirement review in the Annual Audits.