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The Enron scandal, revealed in October 2001, eventually led to
the bankruptcy of the EnronCorporation, an American energy company
based in Houston, Texas, and the dissolution of
Arthur Andersen, which was one of the five largest audit and
accountancy partnerships in theworld. In addition to being the
largest bankruptcy reorganization in American history at thattime,
Enron was attributed as the biggest audit failure.
Enron was formed in 1985 by Kenneth Lay after merging Houston
Natural Gas andInterNorth. Several years later, when Jeffrey
Skilling was hired, he developed a staff ofexecutives that, through
the use of accounting loopholes, special purpose entities, and
poorfinancial reporting, were able to hide billions in debt from
failed deals and projects. ChiefFinancial Officer Andrew Fastow and
other executives not only misled Enron's board ofdirectors and
audit committee on high-risk accounting practices, but also
pressured Andersento ignore the issues.
Shareholders lost nearly $11 billion when Enron's stock price,
which hit a high of US$90 pershare in mid-2000, plummeted to less
than $1 by the end of November 2001. The U.S.Securities and
Exchange Commission (SEC) began an investigation, and rival
Houstoncompetitor Dynegy offered to purchase the company at a fire
sale price. The deal fellthrough, and on December 2, 2001, Enron
filed for bankruptcy under Chapter 11 of theUnited States
Bankruptcy Code. Enron's $63.4 billion in assets made it the
largest corporatebankruptcy in U.S. history until WorldCom's
bankruptcy the following year.
Many executives at Enron were indicted for a variety of charges
and were later sentenced to
prison. Enron's auditor, Arthur Andersen, was found guilty in a
United States District Court,but by the time the ruling was
overturned at the U.S. Supreme Court, the firm had lost themajority
of its customers and had shut down. Employees and shareholders
received limitedreturns in lawsuits, despite losing billions in
pensions and stock prices. As a consequence ofthe scandal, new
regulations and legislation were enacted to expand the accuracy of
financialreporting for public companies. One piece of legislation,
the Sarbanes-Oxley Act, expandedrepercussions for destroying,
altering, or fabricating records in federal investigations or
forattempting to defraud shareholders. The act also increased the
accountability of auditingfirms to remain unbiased and independent
of their clients.
Causes of downfall
Enron's nontransparent financial statements did not clearly
depict its operations and financeswith shareholders and analysts.
In addition, its complex business model and unethicalpractices
required that the company use accounting limitations to
misrepresent earnings andmodify the balance sheet to portray a
favorable depiction of its performance. According toMcLean and
Elkind in their bookThe Smartest Guys in the Room, "The Enron
scandal grewout of a steady accumulation of habits and values and
actions that began years before andfinally spiraled out of
control." In an article by James Bodurtha, Jr., he argues that from
1997until its demise, "the primary motivations for Enron's
accounting and financial transactionsseem to have been to keep
reported income and reported cash flow up, asset values
inflated,
and liabilities off the books."
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The combination of these issues later led to the bankruptcy of
the company, and the majorityof them were perpetuated by the
indirect knowledge or direct actions of Lay, Jeffrey
Skilling,Andrew Fastow, and other executives. Lay served as the
chairman of the company in its lastfew years, and approved of the
actions of Skilling and Fastow although he did not alwaysinquire
about the details. Skilling, constantly focused on meeting Wall
Street expectations,
pushed for the use of mark-to-market accounting and pressured
Enron executives to find newways to hide its debt. Fastow and other
executives "...created off-balance-sheet vehicles,complex financing
structures, and deals so bewildering that few people could
understandthem."
Corporate governance
Healy and Palepu write that a well-functioning capital market
"creates appropriate linkages ofinformation, incentives, and
governance between managers and investors. This process issupposed
to be carried out through a network of intermediaries that include
assuranceprofessionals such as external auditors; and internal
governance agents such as corporateboards." On paper, Enron had a
model board of directors comprising predominantly outsiderswith
significant ownership stakes and a talented audit committee. In its
2000 review of bestcorporate boards, Chief Executive included Enron
among its top five boards.Even with itscomplex corporate governance
and network of intermediaries, Enron was still able to
"attractlarge sums of capital to fund a questionable business
model, conceal its true performancethrough a series of accounting
and financing maneuvers, and hype its stock to
unsustainablelevels."
Executive compensation
Although Enron's compensation and performance management system
was designed to retainand reward its most valuable employees, the
setup of the system contributed to adysfunctional corporate culture
that became obsessed with a focus only on short-termearnings to
maximize bonuses. Employees constantly looked to start high-volume
deals, oftendisregarding the quality of cash flow or profits, in
order to get a higher rating for theirperformance review. In
addition, accounting results were recorded as soon as possible to
keepup with the company's stock price. This practice helped ensure
deal-makers and executivesreceived large cash bonuses and stock
options.
The company was constantly focusing on its stock price.
Management was extensivelycompensated using stock options, similar
to other U.S. companies. This setup of stock optionawards caused
management to create expectations of rapid growth in efforts to
give theappearance of reported earnings to meet Wall Street's
expectations. The stock ticker waslocated in lobbies, elevators,
and on company computers. At budget meetings, Skilling woulddevelop
target earnings by asking "What earnings do you need to keep our
stock price up?"and that number would be used, even if it was not
feasible. At December 31, 2000, Enron had96 million shares
outstanding under stock option plans (approximately 13% of
commonshares outstanding). Enron's proxy statement stated that,
within three years, these awardswere expected to be exercised.
Using Enron's January 2001 stock price of $83.13 and thedirectors
beneficial ownership reported in the 2001 proxy, the value of
director stock
ownership was $659 million for Lay, and $174 million for
Skilling.
