Enron Scandal (Case Study)

Enron Corporate Scandal Case

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.
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.
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 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.
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.
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-tomarket 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.
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.
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.

INSTRUCTION:
This is 1997. Your firm has been employed as an independent consultant to the board of
directors of JAX; a company in similar core businesses as ENRON. This company is seen as
very innovative and also one of the majors of the energy industry. A preliminary independent
audit has revealed that JAX is guilty of similar unethical practices as ENRON. Your job is to give
recommendations based on the limited information available. Your recommendation should be
relevant to the key issues at stake, have reasonable basis, and should be actionable.

QUESTIONS:
a. What are the key issues in this case?
a. Who do these issues affect the most?
b. Who is responsible for these issues?
b. What is likely to be the root cause of these issues?
c. What conditions would a good solution fulfill?
d. What are some alternative ways in which the problem(s) can be solved?
e. Which of these actions/combinations of actions represents the best solution? Why? Why not the others?
f. What are the possible problems/limitations of this solution?
g. How would the solution be implemented?
a. Timing
b. Resource Requirements
c. Stakeholder buy-in