~ By Mansha Khanna and Aditya Kukreja
The Enron scandal, a series of events that resulted in the unexpected collapse of the Enron Corporation, was among the greatest bankruptcy filings and corporate accounting scandals ever witnessed in the history of the United States, with long-lasting repercussions in the financial world.
Enron Corporation got established in 1985, following the merger of two regional energy entities, namely Houston Natural Gas and InterNorth. Following the deregulation of the energy market in the early 1990s, the company lost its exclusive right to operate its pipelines. To increase its profitability, the company transformed itself into a trader of energy derivative contracts, acting as an intermediary between natural gas producers and their customers. After the company started making huge profits, the management started expanding its operations. It was ready to create a market for anything that anyone was willing to trade and thus traded derivative contracts for a wide variety of commodities—including electricity, coal, paper, and steel—and even for the weather. The bull market of the 1990s fueled Enron’s ambitions and contributed to its economic growth. The company got widely recognized as one of the most creative, fastest expanding, and best-run corporations in the United States just months before the insolvency filings.
Many consider adopting Mark-to-market accounting (a strategy that calculates the value of the securities and assets based on their "fair" or market value instead of its book value), the beginning of the end for the company. It allowed the company to write unrealized future earnings from trading contracts into current income statements, thus portraying the illusion of higher current earnings. CEO Jeffrey Skilling concealed the financial losses of the trading business and other activities of the company using the same method. The company which was named "America's Most Innovative Company" by Fortune magazine every year between 1996 and 2001, started crumbling under its own weight by the fall of 2000 but managed to get away with it without anyone so much as doubting until August 2001. From its peak of worth $90.75, Enron’s shares plummeted to as low as $0.26, just before the declaration of bankruptcy on 2nd December 2001. As a result of the falling share prices, the participants of the company’s retirement plan- 401(k) had to suffer catastrophic losses as nearly 62% of the assets held in the corporation's 401(k) pension plan consisted of Enron’s stock.
However, it was not just MTM that led to this decline but many unwitting participants.
Blockbuster, the former Juggernaut video rental company, was one of the many unwitting participants in the scandal. Enron Broadband Services and Blockbuster entered a partnership in July 2000 to enter the burgeoning market for Video on demand (VOD). The VOD market was the fair pick, but Enron began logging projected earnings based on the expected growth of the VOD market, which massively inflated the figures.
As the dot-com bubble began to burst, it decided to create high-speed broadband telecommunications networks. Hundreds of millions of dollars were spent on this initiative, but the company ended up making almost no return. So Enron set up several special shell corporations known as SPVs (Special Purpose Vehicles); which are subsidiaries created by a parent company to isolate financial risk; to dump its non-performing assets. Any losses incurred by it were shown in the SPV’s balance sheet instead of its own, thus again making the company’s financial position look far better than what it was. Enron’s SPVs were mostly capitalized by its own stock, which was further used by the SPVs to hedge the assets on the company’s balance sheet.
However, things could not go on like this much longer. By the summer of 2001, Enron found its stocks declining rapidly. CEO and Founder Kenneth Lay had retired in February, turning over the position to Jeffrey Skilling. In August 2001, Skilling resigned as CEO due to “personal reasons”. Analysts began downgrading their rating for Enron's stock, and shortly thereafter, SEC announced an investigation into Enron and its SPVs. It was found that from 1997 till the end of 2000, Enron had losses of $591 million and $690 million in debt. The last nail in Enron’s coffin was when its merger with another company, Dynegy, fell through; following which it filed for bankruptcy.
Shareholders lost $74 Billion in this entire fiasco. However, the corporation was only able to repay 21.7 billion dollars between 2004 and 2011, the last of which was in May 2011. Many members of management were sentenced to serve jail terms and pay hefty amounts as penalties.
Over the next few years, the name "Enron" became synonymous with major corporate fraud and corruption.
The core of the Enron fiasco was that there was a high level of knowledge asymmetry between the management team and the company's investors. Thus, the scandal resulted in a series of new rules and legislation intended to improve the quality of financial reporting by publicly traded corporations. The most important of these initiatives, the Sarbanes-Oxley Act (2002), introduced strict penalties for the destruction, modification, or manufacture of financial documents.