Enron Scam: The biggest scam in the history of America

Introduction

Enron Scam is the name of an institutional fraud committed by a corporation Enron registered in the United States of America. The
scam was a result of faulty accounting of the company’s assets.

Enron Corporation (hereinafter referred as ‘Enron’) was an American energy, commodities and services company based in
Houston, Texas. It came into existence in the year 1985 as a merger between Houston natural Gas and Internorth, both being
relatively small regional companies. In its initial years, the company was simply a natural gas provider. By the year 1989, it began
trading in natural gas commodities, and by the year 1994 it started trading in electricity as well. That’s how quick the transformation
and enlargement of the company occurred. It employed approximately 20,000 persons. It was one of the world’s leading electricity,
natural gas, paper and communication companies which claimed approximate revenue of nearly $101 billion in the year 2000. The
company extensively dealt in the trade of sugar, coffee, grains, hog and other meat products. The company made revolutionary
changes in the energy trading which allowed it to grow overnight. Enron tailored electricity and natural gas contracts which
effectively minimized the cost of the same. In essence, it became nation-wide and soon a global energy trading corporation.
Fortune named Enron as “America’s Most Innovative Company” for six years in a row. By the end of 2001, it was revealed that
there are huge errors in the accounting of Enron so much so that Enron had to file for bankruptcy in December 2001.

Issue

The scam came into notice when the balance sheets of Enron were analysed and they did not make any sense to analysts. Enron
was seen to be shifting its debt obligations to offshore partnerships, mainly created by the Chief Financial Officer of the
company Andrew Fastow. The company was also reporting inaccurate trading revenues. Some mala fide practices of Enron
included serving as a middleman in a contract, then showing the entire sale as Enron revenue. Enron also used its various
partnerships to sell their own contracts to themselves.

In February 2001, Jeffrey Skilling, the president of Enron, took over as the CEO of the company. He soon resigned abruptly. After
his resignation, it came into cognizance of the company about a possible accounting fraud. Before the troubles of Enron could
calm, the firm shocked its investors in October with an announcement that the company has been undergoing huge losses. In the
third quarter of 2001, the company officially registered a loss of $638 million. It took a $1.2 billion reduction in shareholder equity.

An important role here was played by Arthur Andersen LLP, one of the largest public accounting firms in 1990s, with approximately
85,000 employees operating in 84 nations. This LLP was Enron’s accountant and auditor as well. In the year 2002, the partnership
was found guilty of destroying documents relating to Enron audits, which amounts to obstruction of justice. The decision was later
unanimously overturned by the Supreme Court of the United States of America. By September 2001, Enron insiders decided to
declare losses for the third quarter. Arthur then went into crisis management mode in anticipation of SEC investigation. In October
2012, the company destroyed all extraneous documents by complying with the company’s documentation retention policy.

The SEC had begun an inquiry into Enron and the partnerships. After a week of inquiry, a full investigation was launched against
the company. The SEC even issued a cease and desist order against Anderson regarding security violations in some other
company. When Anderson was asked to provide the Enron audit documents, it couldn’t comply. Various companies which were
audited by Anderson were under the scrutiny of SEC for fraudulent acts which evidenced of an error on the part of Anderson as
well. This forced the company to abruptly declare bankruptcy. The company was found guilty of shredding of documents which
also amounted to obstruction of justice, a felony under the federal laws of the USA. Arthur Anderson lost its license to engage in
public accounting when the Justice Department declared it guilty. Three years later, the Supreme Court overturned the judgment
but the firm had lost all its clientele by then. Soon, the company vanished.

The Scam

Enron scandal is the name for the events that led to the bankruptcy of the US energy, commodities and services company Enron
and dissolution of its auditor Arthur Anderson LLP. Enron held more than $60 billion worth of assets, when it abruptly filed for the
biggest bankruptcy in the history of the USA leaving long lasting repercussions on the financial world.

To understand the scam in detail, we must understand the two concepts of market system, the Bullish and the Bearish system. The
Bear system is more into trial and error. The investments and capitalisation is on daily level. The fluctuations are also regular and
very evident. Whereas in Bullish system, the market is stabilised at all times. The stock market has mostly been Bullish. Enron took
the benefit of the Bullish system of market and grew overnight. The company was ready to create a market for anything and
everything in which anyone was willing to trade. It made derivative contracts for a wide range of commodities like electricity, coal,
paper, steel and even weather reporting. The company also invested in building a broadband telecommunication network to
facilitate high speed trading. This was a period of boom for the economy when there was a market for every commodity. Soon, the
system changed. The company was facing increased competition and its profits shrank rapidly. To compete, and to avoid the
pressure from shareholders, the company began a practice of dubious accounting known as ‘mark-to-market’ under which the
company accounts showed the future gains from trading contracts into current income statements, thus fooling the investors by
showing higher profits than they actually were. The troubled operations of the company were transferred to Special Purpose
Entities (hereinafter referred as ‘SPEs’), to limit the partnerships created with outside parties. Enron used the SPEs as a dump site
for its troubled assets. Transferring the assets to SPEs meant that the same need not be shown in company’s books, which made
the losses look less severe than they actually were. All this while, Arthur Anderson worked not only as the auditor of the company
but also as a consultant for the company. This was seen as a fraud and malicious practice against the investors who were not told
the truth before they planned to invest in the company.
The matter came into notice when various analysts began to dig into the financial statements of Enron. An internal investigation
took place, headed by the Vice President of the company, which was soon followed by an official investigation by the SEC
analysing the transactions between Enron and the SPEs. Soon after, Enron filed for bankruptcy . The Enron executives were
indicated on a variety of charges and were later sentenced to prison. Along with the federal lawsuits, multiple civil suits were filed
by the shareholders against Enron.

Class Action Suit

A class lawsuit was brought by former Enron employees, who held company’s stocks at the time the company filed for bankruptcy
in November, 2001. They suffered huge losses in their retirement savings plan. The defendants in the case were Enron, members
of its Board, its executives and employees, the institutional trustee Northern Trust Company and the auditor of Enron, Arthur
Anderson. The violations were from the Employee Retirement Income Security Act, 1974 (hereinafter referred as ‘ERISA’). The
court held that the corporate officers and employees who are appointed by the employer to administer its retirement plan may be
held personally liable. The defendants further breached their fiduciary duty to disclose accurate information about Enron’s financial
condition. It defrauded the people for investing in the company. Northern Trust acted as a trustee for the company, which puts a
fiduciary responsibility on the company to make the persons investing aware of the dangers of the plan. Northern Trust was
declared liable under ERISA for failing to override the directions received by the company. The suit against Arthur Anderson was
upheld as well for knowingly participating in hiding the truth about Enron’s financial condition. The compensation in this case
amounted to $7.2 billion which was paid out by a group of banks accused of participating in the fraud and breach of fiduciary duties.

Downfall of Enron

Enron grew manifold in the short time span of 20 years. But, it also saw the most abrupt downfall ever by going for bankruptcy from
a market capitalisation of $60 billion in a year. The reasons for its downfall were many, mainly that the financial statements of the
company were confusing the shareholders and analysts. Its business model was very complex that most people could not
understand, the company was falling into many unethical practices. The company even used its accounting limitations to
misrepresent its earnings and modify the balance sheet to indicate favourable performance. The company kept finding ways to hide
its debt till the extent that the company went into total losses. The company’s officers prepared such balance sheets, complex
financial structures and bewildering deals that no one could understand them, let alone wishing to invest. Therefore, the company
sunk into losses and had to go for bankruptcy.

Repercussions

The whole scam was a huge setback for America. To avoid the slightest possibility of such an incident in future, new regulations
and legislations were introduced to improve the accuracy of financial reporting of public companies. The Sarbanes-Oxley Act, 2002
also called as “Public Company Accounting Reform and Investor Protection Act” and “Corporate and Auditing Accountability,
Responsibility, and Transparency Act” was passed by the US Senate which provides for a set of enlarged requirements for all US
Public Company Boards and managements relating to destroying, altering or fabricating records in investigations and attempting to
defraud shareholders. The Act also increased the accountability of auditing firms, in order to make them unbiased and independent
of their clients. It provides for a criminal penalty for such acts, which is a welcome step as it will surely deter companies from
involving in fraud and the auditors from supporting the same. The Act also prohibited auditing firms to act as a consultant for the
same clients as well as had happened in the present case.

Timeline of Events

1985- Houston Natural Gas merges with Inter North to form Enron.

1989- Enron enters the natural gas commodities trading market.

1990- An energy consultant was hired to run a new subsidiary called Enron Finance Corporation.

October 16, 2001– Enron announced a third quarter loss of $168 million. The company later confessed that it overstated its
earnings since 1997.

October 31, 2001- SEC initiates a formal investigation against the company.

November 2001- There were headlines regarding the merger of Enron with rival company Dynergy, which was denied by Dynergy.

January 2002- The US Department of Justice started a criminal proceeding against Enron’s collapse.

January 10, 2002- Arthur Anderson LLP, the accounting firm that handled Enron’s audits, disclosed that the company has
destroyed all the relevant documents.

January 15, 2002- The New York Stock Exchange suspends trading of Enron shares on its stock exchange.

January 17, 2002- Enron- Arthur partnership ended.

March 2002- Arthur declared guilty of obstruction of justice and its licence to audit pubic companies was revoked.
2006- The company officials Skilling and Lay were convicted of fraud and conspiracy. Additional charges of insider trading and
making false statement were proved. Lay died of heart attack while awaiting sentence.

2008- A class action lawsuit was filed by shareholders and investors of Enron and the settlement was arrived at in the federal
court. An amount of $7.2 billion was paid out by a group of banks accused of participating in the fraud.

2013- Skilling’s sentence was reduced as he forfeited $42 million to be distributed among the victims of Enron fraud.

2015- The SEC announced its judgement against Skilling barring him from serving as an officer or Director of any public company.

February 21, 2019- Skilling was finally released after serving over 12 years in the federal prison.

Lessons Learnt from Enron Scandal

The following lessons can be learnt from the scandal which shook the Wall Street majorly-

• There should be a healthy corporate culture in a company. The executives of Enron believed Enron was best at everything
and jumped into any possible new arena. The shareholders were overly optimistic. Hiding the losses of company in order
to protect the name and reputation wasn’t a great idea.
• A more holistic system is required for supervision of the company by shareholders, so that the executives are under a
constant scrutiny of the shareholders.
• The government needs to make more stringent norms regarding public companies as their downfall hits the entire
economy of the country, like in the present case.
• The approval of US government to use an immoral and illegal method ‘mark-to-market’,which is nothing but a manner to
fool the investors, and to hide the losses of the company. Long term gains cannot be made out of this system. The
ignorance regarding the drawbacks of this system is a failure on the part of government as it hides the major accounts of
the company.
• This case is the best example of antithesis of ethics. A company is such an organisation where there are multiple
possibilities of fraud and demeanour. It is of utmost importance to follow business ethics and be loyal to each other for all
employees of the company. In the present matter, the company officials defrauded their own employees by hiding the
accounts of the company from them.

Potential Solution

While going through news reports, we find that the cases of financial fraud have grown manifold over the last few years. This has
been one of the most deterring factors for the people with lesser knowledge about this sector from investing their capital and
contributing in the growth of a country’s economy. To bring about a decline in this culture of corporate scams, the following
systematic changes need to be brought-

• The law for protection of Whistle Blowers is imperative. More people will come forth to give information if they are given
assurance of their protection.
• The regulating agencies involved in these cases should be provided with greater autonomy and less political influence.
• An essential judicial reform to provide for fast disposal of such matters, so that the consequences are severe and
immediate.

Conclusion

A corporate scam of this level, that too in a country like America, which is known for its very stringent laws is a shame on our
morals and a never undying greed for money. Even with all the laws coming up in this regard, we will not be able to curb these
incidents because of the lack of activism in the judicial mechanism, the omnipresent loopholes and the power of money.
Nonetheless, this case is an example of how the wrong will not prevail in the end irrespective of how fool proof it was. The
company’s collapse not only affected thousands of its employees but also shook the Wall Street to its core.