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Kenneth L. Lay became the Chief Executive Officer of HoustonÂ Natural GasÂ Corporation in 1984. Shortly after getting his position, his firm merged with Internonth, which was another pipeline company. Ken was then the CEO of the merged firm. This merged firm was named the Enron Corporation.Â It had become to be known as one of the largest corporations in the US in aspects of its overall value and growth. It took Enron only 15 years to grow from nothing to America's seventh largest company which employed 21,000 staff across over 40 countries.
But the achievement of this firm later turned out to have drawn in a highly structured scam. Enron dove from being the 7th largest US Company to the largest bankruptcy in less than a year. Â At the end of 2001, it was exposed that Enron's reported economic condition was sustained largely by organized and creatively planned accounting fraud, known as the "Enron scandal". Enron since then has become a popular figure of corporate scam and corruption.(BBC, 2002)
This essay highlights the details of activities that led to Enron's bankruptcy or in other words how the "house of cards" crashed.
Mark to Market:
In the year 1992, Jeff Skilling; who was the president of Enron, tried to convince the federal regulator to start the use of an accounting technique called "mark to market" and succeeded. This technique was earlier seen to be used by only trading and brokerage companies. Under this accounting technique, the value or price of a security was to be recorded on an everyday basis to ascertain the profits and losses. By using this accounting method, Enron was allowed to calculate the anticipated earnings from a long-term contract as their current income. This means that Enron was counting the money that might not be collected for many years as a part of its current income. For example, if a company made profits of 20 billion in 1999, it would made a profit of 120 billion USD next year. (Gibney, 2005) It was understood that Skilling suggested this technique to inflate the present revenue numbers in the financial statements but also manipulating the projections of future possible revenue.
Use of this method made it extremely difficult to anticipate the way Enron was really making money. All the entries were made in the books which led to stock prices to remain high but Enron wasn't paying high amounts of taxes. Robert Hermann, the company's general tax counsel at the time, was told by Skillings that this accounting method of mark to market would allow Enron to grow and make money without bringing in huge amounts of taxable cash. (Obringer)
There was a charge brought against Enron which is referred to as insider trading. Previous Enron officials have been blamed for making $1 billion in stocks. In simple words, the officials of Enron, sold their securities/stock which was worth $1 billion before Enron's stock prices fell drastically in order to keep their financial positions under control.
Special purpose entities
Enron used special purpose entities SPEs-limited partnerships /companies which were established to created to accomplish a definite purpose which in this case was to fund and manage risks that were associated with certain specific assets.Â In totality, by 2001, Enron had used hundreds of special purpose entities to hide from view its debt. Under Fastow's headship, Enron took the use of SPEs to a greater level of difficulty and superiority, capitalizing them with not only a variety of hard assets and liabilities, but also extremely complex derivative financial tools, related liabilities and its own restricted stock. The most controversial of them were LJM Cayman LP and LJM2 Co-Investment LP, which were both run by Fastow himself. In three years of establishment which is from 1999 till 2001, these SPEs remunerated Fastow with more than $30 million in management fees, which was way more than the remuneration he was getting from Enron. This was all supoosedlyl done with the approval of the top management and also the board of directors of Enron. In turn, the LJM partnerships invested in another group of SPEs, known as the Raptor vehicles. Following this practice isn't wrong only if there is rightful and true transfer of ownership. But in case of Enron's SEPs there was never any sort of transfer of ownership shown in the financial accounts. Taking these enormous risk in order to sustain, eventually led to Enron's downfall. Though Andrew Fastow earned a lot of money from running the limited partnership companies as he was active from both the parts of the transactions, for this, he was sacked.
California never had a shortage of power. But the day had come. Two days of no electricity, complete blackouts in June 2000. This had marked the start of California's Energy Crisis. This was directed to be caused by scheming energy trading by traders of Enron. These traders were caught on tape for telling California power plant managers to "get a little creative" in shutting down these plants for "repairs". (CBSENEWS, 2000) . The Federal Energy Regulation Commission revealed that the Enron Corporation had deliberately caused the actual and made-up shortages during the year 2000-2001. The effects of the blackouts were seen on more than hundreds of thousands of companies and residential consumers, some of them being trapped in elevators. Offices as big as Cisco Systems and Apple Computer were shut down, which cost them millions of dollars as unavoidable lost revenue. This was done in order to bring up the prices of the stock and to obtain the vast earnings from the state's recently deregulated energy market.
When asked by the traders why this was done, they said that Enron's former president, Jeff Skilling, was the person who push them to "trade aggressively" and to carry on necessary actions to gain benefit of the state's extensive market to boost the prices of Enron's stock. Skilling was said to threaten the traders of losing their job if they weren't able to carry on with aggressive trading even if it came at cost of putting California under misery. (Leopold, 2002)
Giant auditing firm Arthur Anderson was engaged in extensive criminal conduct by shredding tons of Enron documents. Anderson had full knowledge that these documents would bring about a lot truths which were relevant to the investigation of Enron's downfall. The prosecutors found out that there were 30 trunks of records that were shredded before the investigation. Employees were knowingly and intentionally persuaded by Anderson to work overtime in order to complete the process of altering, destroying, mutilating and concealing the documents. The shredding started a few days after Enron openly corrected its books which reported a $1.2 billion fall in the value of the firm. This was done by Andersen in order to escape from being caught for not abiding by the rules of entering every transaction in the books of accounts with accuracy. By practicing this, Arther Anderson had to quit the auditing field and lost a lot clients including some of the big firms like Delta Airlines.
Enron's culture was described as that of having pride. Even if that led to make people believe that undertaking great risks wouldn't in turn be of any form of danger. Accroding to Sherron Watkins, "Enron's unspoken message was, 'Make the numbers, make the numbers, make the numbers-if you steal, if you cheat, just don't get caught. If you do, beg for a second chance, and you'll get one.'" (Gibney, 2005)
This kind of corporate culture was never really of any help in promoting the values of respect and integrity. Instead these values were undermined through the company's practices of employee performance assessment, its compensation programs and decentralization.
Corporate governance failed for Enron due to a lot of reasons which eventually led to hiding their debt and being fraudulent. Secondly, the creation of SEPs/limites partnerships. These companies were headed by executives of Enron and were ultimately backed by Enron stock. They didn't count their limited partner's debt as their own by using the off-balnce sheet accounting techniques. All the above issues depict how fragile the corporate governance was during that decade as compared to today.
Changes made in the regulatory framework post Enron
The reaction of the government was aggressive when they became aware of Enron's downfall and its scandal. Proposals were made as to how was the best way to deal with this situation. The then President Bush had even announced even a post-Enron plan.Â According to this plan all firms were to make complete disclosure in the financial statements and make these financial statements more informative and clear. This plan also was to put across higher financial responisilites for the accountants and CEPs of the company. higher levels of financial responsibility for CEOs and accountants.Â This was done so as to reduce the undue burden from the hinest accountants that existed in the industry. (Schlesinger)
Changes were made in Sarbanes-Oxley Act as well. The biggest change that was made in the act was that the companies were now required to reevaluate its internal audit processes in order to know if the company is running in accordance with what the auditors would call fair. It was also included that, higher level of employees were to be employed as CFOs and CEOs Â to have a better and clear understanding of how the company is being run which is headed by them and not by staying aloof about its happenings. There were new requirements that were made for the disclosures made by the companies. These transactions were to be called reportable transactions. All these transactions were broken down into several categories clearly stating the impact on the business by each of them.Â These requirements were accompanied were strict penalties if these were not reported and later exposed.