Enron scandal

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Enron Corporation

Type	Defunct / Asset-less Shell
Founded	Omaha, Nebraska, 1985
Headquarters	Houston, Texas, United States
Key people	Kenneth Lay, Founder, former Chairman and CEO Jeffrey Skilling, former President, CEO and COO Andrew Fastow, former CFO Rebecca Mark-Jusbasche, former Vice Chairman, Chairman and CEO of Enron International Stephen F. Cooper, Interim CEO and CRO John J. Ray, III, Chairman
Industry	formerly Energy
Revenue	$101 billion (in 2000)
Employees	approx. 22,000 in 2000 approx. 4 as of 2008.
Website	http://www.enron.com/

The Enron scandal was a corporate scandal involving the American energy company Enron Corporation based in Houston, Texas and the accounting, auditing and consultancy firm Arthur Andersen, that was revealed in October 2001.

Enron’s stock price (former NYSE ticker symbol: ENE), which hit a high of $90 per share in mid-2000, plummeted to $0.10 in October 2001. The drop in Enron’s stock price is estimated to have caused its stock holders to lose $11 billion. On December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code, and with assets of $63.4 billion, it was the largest corporate bankruptcy in U.S. history until WorldCom declared bankruptcy in 2002.^[1]

In addition to being the largest bankruptcy reorganization in American history, Enron undoubtedly is the biggest audit failure.^[2] The scandal caused the dissolution of Arthur Andersen, which at the time was one of the five largest accounting firms in the world.

One consequence of these events was the passage of Sarbanes-Oxley Act in 2002, as a result of the first admissions of fraudulent behavior made by Enron. The act significantly raises criminal penalties for securities fraud, for destroying, altering or fabricating records in federal investigations or any scheme or attempt to defraud shareholders.^[3]

[edit] The rise of Enron

Kenneth Lay, July 2004 (United States Marshals Service)

Kenneth Lay founded Enron in 1985 through the merger of Houston Natural Gas and InterNorth, two natural gas pipeline companies.^[4] In the early 1990s the Congress of the United States of America passed legislation deregulating the sale of natural gas. The resulting energy markets made it possible for companies like Enron to thrive, while the resultant price volatility was often bemoaned by producers and local governments.^[5] Strong lobbying on the part of Enron and others, however, kept the system in place.^[6][7]

By 1992, Enron was the largest merchant of natural gas in North America, and the gas trading business became the second largest contributor to Enron’s net income, with an Earnings Before Interest and Taxes of $122 million. The creation of the online trading model, EnronOnline, in November 1999 enabled the company to further develop and extend its abilities to negotiate and manage its trading business.^[8]

In an attempt to achieve further growth, Enron pursued a diversification strategy. By 2001, Enron had become a conglomerate that owned and operated gas pipelines, electricity plants, pulp and paper plants, broadband assets, and water plants internationally, and traded extensively in financial markets for the same products and services.^[9]

As a result, Enron’s stock rose from the start of the 1990s until year-end 1998 by 311% percent, a modest increase over the rate of growth in the Standard & Poor 500 index. The stock increased by 56% in 1999 and a further 87% in 2000, compared to a 20% increase and a 10% decline for the index during the same years. By December 31, 2000, Enron’s stock was priced at $83.13 and its market capitalization exceeded $60 billion, 70 times earnings and six times book value, an indication of the stock market’s high expectations about its future prospects. In addition, Enron was rated the most innovative large company in America in Fortune’s Most Admired Companies survey. ^[10]

[edit] Financial reporting

Its famously opaque financial statements showed that Enron found it neither necessary nor desirable to share a clear picture of its operations and finances with either its own shareholders or the wider financial community.^[11] Enron’s complex business model stretched the limits of accounting. Enron took full advantage of accounting limitations in managing its earnings and balance sheet to portray a rosy picture of its performance. Two sets of issues proved especially problematic:^[12]

• First, its trading business involved complex long-term contracts. Current accounting rules use the present value framework to record these transactions, requiring management to make forecasts of future earnings. This approach, known as mark-to-market accounting, was central to Enron’s income recognition^[13];
• Second, Enron relied extensively on structured finance transactions that involve setting up of special purpose entities. These transactions shared ownership of a specific cash flows and risks with outside investors and lenders. Traditional accounting, which focuses on arms-length transactions between independent entities, faces challenges in dealing with such transactions.^[14]

[edit] Mark-to-market accounting

In Enron’s original natural gas business, the accounting had been fairly straightforward: in each time period, the company listed actual costs of supplying the gas and actual revenues received from selling it. However, Enron’s trading business adopted mark-to-market accounting, which meant that once a long-term contract was signed, income was estimated as the present value of net future cash flows, even though in some cases there were serious questions about the viability of these contracts and their associated costs. ^[15]

For example, in July 2000 Enron signed a 20 year agreement with Blockbuster Video to introduce entertainment on-demand to multiple U.S. cities by year-end. Enron would store the entertainment, and encode and stream the entertainment over its global broadband network. Pilot projects were created to stream movies to a few dozen apartments from servers set up in the basement. Based on these pilot projects, Enron went ahead and recognized estimated profits of more than $110 million from the Blockbuster deal, even though there were serious questions about technical viability and market demand. ^[16]

[edit] Special purpose entities

Enron used special purpose entities to fund or manage risks associated with specific assets. Special purpose entities are shell firms created by a sponsor, but funded by independent equity investors and debt financing. For financial reporting purposes, a series of rules is used to determine whether a special purpose entity is a separate entity from the sponsor. In total, Enron had used hundreds of special purpose entities by 2001.^[17]

[edit] JEDI and Chewco

For example, in 1993, Enron set up a joint venture in energy investments with CalPERS, the California state pension fund. It was called Joint Energy Development Investments (JEDI). In 1997, COO Jeffrey Skilling wanted Calpers to enter into an unrelated investment arrangement with Enron. Calpers was willing, but only if it first was cashed out of JEDI.^[18] However, Enron did not want to show any debt from financing the acquisition or from the joint venture on its balance sheet. Chewco Investments L.P., a special purpose entity that was controlled by an Enron executive (Michael Kopper), and raised debt that was guaranteed by Enron, acquired the joint venture stake for $383 million.^[19]

Chewco and several other special purpose entities, however, did more than just skirt accounting rules. As Enron revealed in October 2001, they actually violated accounting standards that require at least 3% of assets to be owned by independent equity investors. As a result, Enron’s balance sheet understated its liabilities and overstated its equity, and its earnings were overstated.^[20]

The arrangement came to light within Enron in fall 2001, disqualifying its previous accounting treatment of Chewco and JEDI. Disqualification in fall 2001 meant consolidation of JEDI and Chewco with result that Enron’s earnings for 1997-mid 2001 were retroactively reduced by $405 million. Meanwhile, consolidation increased its total indebtedness $628 million.^[21]

[edit] LJM and Raptor

In addition to the accounting failures, Enron chose to provide minimal disclosure on its relations with the special purpose entities. The company represented to investors that it had hedged downside risk in its own illiquid investments through transactions with special purpose entities. Yet investors were unaware that the special purpose entities were actually using Enron’s own stock and financial guarantees to carry out these hedges, so that Enron was not actually protected from downside risk.^[22]

In 1999 CFO Andrew Fastow organized two limited partnerships, LJM Cayman. L.P. (LJM1) and LJM2 Co-Investment L.P. (LJM2). The entities were formed to participate as the outside equity investor in special purpose entities set up by Enron. LJM 1 and 2 were funded with around $390 million of outside equity contributed by J.P. Morgan Chase, Citigroup, Credit Suisse First Boston, and Wachovia. Merrill Lynch, which marketed the equity, also contributed $22 million. ^[23]

Enron transferred to the LJM-related special purpose entities ("Raptor I-IV") more than $1.2 billion in assets, including millions of shares of Enron common stock and long term rights to purchase millions more shares, plus $150 million of Enron notes payable. The special purpose entities had paid for all of this with their own debt instruments with a face amount of $1.5 billion, and had entered into derivative contracts with Enron with a notional amount of $2.1 billion. ^[24]

When it capitalized the LJM-related Raptor I-IV special purpose entities, Enron booked the notes payable issued by them as assets on its balance sheet and increased its shareholders’ equity in a like amount, as one would do when selling newly issued common stock for cash in a public offering. The management of Enron and its auditors Arthur Andersen later thought better of the treatment. Unwinding it meant the sudden and highly embarrassing disappearance of $1.2 billion from Enron’s net shareholder equity.^[25]

The derivative contracts with Enron with a notional amount of $2.1 billion did lose value. Enron set up the swaps just as the subject stock prices hit peaks. The value of the portfolio under the swaps fell by $1.1 billion across five fiscal quarters, so that the special purpose entities owned Enron $1.1 billion under the contracts. Enron, using the new “fair value” accounting, marked the value of its rights under the swap contracts to market for income statement purposes. Enron’s Annual report for 2000 showed a $500 million gain on the swap contracts which exactly offset its loss on the stock portfolio. This $500 million made up about one third of Enron’s earnings for 2000 (prior to restatement in 2001).^[26]

A scandal resulted with the disclosure that Andrew Fastow had raked in $30 million from compensation arrangements respecting his management of the LJM limited partnerships in October 2001. The SEC launched an investigation on October 22. Fastow got the sack two days later.^[27]

[edit] Corporate Governance

A well-functioning capital market creates appropriate linkages of information, incentives, and governance between managers and investors. This process is supposed to be carried out through a network of intermediaries that include assurance professionals such as external auditors; and internal governance agents such as corporate boards.^[28] On paper, Enron had a model board comprised predominantly of outsiders with significant ownership stakes and a talented audit committee. In its 2000 review of best corporate boards the Chief Executive Magazine included Enron among its top five boards.^[29]

Despite this elaborate corporate governance and intermediation network, Enron was able to attract large sums of capital to fund a questionable business model, conceal its true performance through a series of accounting and financing maneuvers, and hype its stock to unsustainable levels.^[30]

[edit] Executive compensation

As in most other US companies, Enron’s management was heavily compensated using stock options. Heavy use of stock option awards linked to short-term stock price may explain the focus of Enron’s management on creating expectations of rapid growth, and its efforts to puff up reported earnings to meet Wall Street’s expectations. At December 31, 2000, Enron had 96 million shares outstanding under stock option plans, almost 13 percent of common shares outstanding. According to Enron’s proxy statement, these awards were likely to be exercised within three years, and there was no mention of any restrictions on subsequent sale of stock acquired.^[31] Using Enron’s January 2001 stock price of $83.13 and the directors’ beneficial ownership reported in the 2001 proxy, the value of director stock ownership was $659 million for Kenneth Lay, and $174 million for Jeffrey Skilling.^[32]

[edit] Risk Management

Before its fall, Enron was lauded for its sophisticated financial risk management tools.^[33] Risk management was crucial to Enron not only because of its regulatory environment, but also because of its business plan. In response to price and supply volatility risks in the energy industry, Enron placed longterm fixed commitments which needed to be hedged.^[34] Enron’s rapid decline into bankruptcy is clearly linked to its aggressive and questionable use of derivatives and special purpose entities. By hedging its risks with special purpose entities which it owned, Enron retained the risks inherent to the transactions. As such Enron effectively entered into hedges with itself.^[35]

Enron’s high-risk accounting practices were not hidden from the Board of directors. The Board knew of them and took no action to prevent Enron from using them. The Board was briefed on the purpose and nature of the Whitewing, LJM, and Raptor transactions, explicitly approved them, and received updates on their operations. Enron’s extensive off the-books activity was not only well known to the Board, but was made possible by Board resolutions.^[36] Even though Enron was running a derivatives business, it seems that those on the Finance Committee and, more generally on the Board, did not have a sufficient derivatives background to understand and evaluate what they were being told.^[37]

[edit] Financial audit

Enron’s auditor, Arthur Andersen, has been accused of applying lax standards in their audits because of a conflict of interest over the significant consulting fees generated by Enron. In 2000, Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees. Enron’s audit fees accounted for roughly 27 percent of the audit fees of public clients for Arthur Andersen’s Houston office. Whether the auditors at Andersen had conflicted incentives or whether they lacked the expertise to adequately evaluate financial complexities, they failed to exercise sound business judgment in reviewing transactions that were clearly designed for financial reporting rather than business purposes.^[38]

When the credit risks at the special purpose entities became clear, requiring Enron to take a write-down, the auditors apparently succumbed to pressure from Enron’s management and permitted the company to defer recognizing the charges. Internal controls at Andersen, designed to protect against conflicted incentives of local partners, failed. For example, Andersen’s Houston office, which performed the Enron audit, was permitted to overrule critical reviews of Enron’s accounting decisions by Andersen’s Practice Partner in Chicago. Finally,Andersen attempted to cover up any improprieties in its audit by shredding supporting documents after investigations of Enron by the Securities and Exchange Commission became public.^[39]

[edit] Audit committee

Corporate audit committees usually meet for just a few times during the year, and their members typically have only a modest background in accounting and finance. Enron’s audit committee had more expertise than many. It included:

• Dr. Robert Jaedicke of Stanford University, a widely respected accounting professor and former dean of Stanford Business School;
• John Mendelsohn, President of the University of Texas’ M.D. Anderson Cancer Center;
• Paulo Pereira, former president and CEO of the State Bank of Rio de Janeiro in Brazil;
• John Wakeham, former U.K. Secretary of State for Energy;
• Ronnie Chan, a Hong Kong businessman; and
• Wendy Gramm, former Chair of US Commodity Futures Trading Commission.

But Enron’s audit committee seemed to share the common pattern of a few short meetings that covered huge amounts of ground. For example, the Enron’s Audit Committee meeting on February 12, 2001 lasted only one hour and 25 minutes. Enron’s Audit Committee was in no position to second-guess the auditors on technical accounting questions related to the special purpose entities. Nor was it in a position to second-guess the validity of top management representations.^[40]

[edit] Timeline of Enron's downfall

In a conference call on April 17, 2001, Skilling verbally attacked Wall Street Analyst Richard Grubman^[42], who questioned Enron's unusual accounting practice during a recorded conference call. When Grubman complained that Enron was the only company that could not release a balance sheet along with its earnings statements, Skilling replied "Well, thank you very much, we appreciate that . . . asshole." This became an inside joke among many Enron employees, mocking Grubman for his perceived meddling rather than Skilling's lack of tact, with slogans such as "Ask Why ? Asshole". However, Skilling's comment was met with dismay and astonishment by press and public, as he had previously brushed off criticism of Enron cooly or humorously, and many believe that this began a downward spiral that would unravel the company's deceptive practices.^[43]

By the late 1990s Enron's stock was trading for $80–90 per share, and few seemed to concern themselves with the opacity of the company's financial disclosures. In mid July 2001, Enron reported earnings of $50.1 billion, almost triple year-to-date, beating analysts' estimates by 3 cents a share.^[44] Despite this, Enron's profit margin had stayed at a modest average of about 2.1%, and its share price had dropped by over 30% since the same quarter of 2000.^[45]

However, concerns were mounting. Enron had recently faced several serious operational challenges, namely logistical difficulties in running a new broadband communications trading unit, and the losses from constructing the Dabhol Power project, a large power plant in India. There was also mounting criticism of the company for the role that its subsidiary Enron Energy Services had played in the power crisis of California in 2000-2001.

August 14, 2001, Jeffrey Skilling, a former energy consultant at McKinsey & Company who joined Enron in 1990, announced he was resigning his position as chief executive officer after only six months. Skilling had long served as president and chief operating officer before recently being promoted to CEO.

"[T]he reasons for leaving the business are personal," said Skilling at the time, "but I'd just as soon keep that private."^[46] Observers noted that in the months leading up to his exit, Skilling had sold at minimum 450,000 shares of Enron at a value of around $33 million (though he still owned over a million shares at the date of his departure).^[47] Nevertheless, Kenneth Lay, the chairman at Enron, reassured analysts by affirming that there was "[a]bsolutely no accounting issue, no trading issue, no reserve issue, no previously unknown problem issues" prompting the departure. He further assured stunned market watchers that there would be "no change in the performance or outlook of the company going forward" from Skilling's departure.^[48] Lay announced he himself would re-assume the position of chief executive officer.

The next day, however, Skilling admitted that a very significant reason for his departure was Enron's faltering price in the stock market.^[49] The columnist Paul Krugman, writing in the NY Times, asserted that Enron was an illustration of the consequences that occur from the deregulation and commodification of things such as energy.^[50] A few days later, in a letter to the editor, Kenneth Lay defended Enron and the philosophy behind the company:

The broader goal of [Krugman's] latest attack on Enron appears to be to discredit the free-market system, a system that entrusts people to make choices and enjoy the fruits of their labor, skill, intellect and heart. He would apparently rely on a system of monopolies controlled or sponsored by government to make choices for people. We disagree, finding ourselves less trusting of the integrity and good faith of such institutions and their leaders.

The example Mr. Krugman cites of "financialization" run amok (the electricity market in California) is the product of exactly his kind of system, with active government intervention at every step. Indeed, the only winners in the California fiasco were the government-owned utilities of Los Angeles, the Pacific Northwest and British Columbia. The disaster that squandered the wealth of California was born of regulation by the few, not by markets of the many. ^[51]

[edit] Investors' confidence declines

By the end of August 2001, his company's stock still falling, Lay named Greg Whalley, 39, president and chief operating officer of Enron Wholesale Services and Mark Frevert, 46, who was previously Mr. Whalley's superior at Enron Wholesale, to positions in the chairman's office. Some observers suggested that Enron's investors were in significant need of reassurance, not least because the company's business was difficult to understand (even "indecipherable"^[53]) and difficult to properly express in a financial statement.^[54] "[I]t's really hard for analysts to determine where [Enron] are making money in a given quarter and where they are losing money," said one analyst.^[55] Lay accepted that Enron's business was very complex, but asserted that analysts would "never get all the information they want" to satisfy their curiosity. He also explained that the complexity of the business was due largely to tax strategies and position-hedging.^[56]

Lay's efforts seemed to meet with limited success; by September 9, 2001, one prominent hedge fund manager noted that "[Enron] stock is trading under a cloud."^[57] The sudden departure of Skilling combined with the opacity of Enron's accounting books made proper assessment difficult for Wall Street. In addition, the company admitted to repeatedly using "related-party transactions," which some feared could be too-easily used to transfer losses that might otherwise appear on Enron's own balance sheet. A particularly troubling aspect of this technique was that several of the "related-party" entities had been or were being controlled by Enron's Chief Financial Officer (CFO), Andrew Fastow.^[58]

After the September 11, 2001 attacks, media attention shifted away from the company and its troubles; a little less than a month later Enron announced its intention to begin the process of shearing its lower-margin assets in favor of its core businesses of gas and electricity trading. This move included selling Portland General Electric to another Oregon utility, Northwest Natural Gas, for about $1.9 billion in cash and stock, and possibly selling its 65% stake in the Dabhol project in India.^[59]

[edit] Restructuring Losses and SEC Investigation

On October 16, 2001, Enron announced that restatements to its financial statements for years 1997 to 2000 to correct these violations would reduce earnings for the four year period by $613 million (or 23% of reported profits during the period), increase liabilities at the end of 2000 by $628 million (6% of reported liabilities and 5.5% of reported equity), and reduce equity at the end of 2000 by $1.2 billion (10% of reported equity).^[60]

Enron management claimed the losses were mostly due to investment losses, along with charges such as about $180 million in money spent restructuring the company's troubled broadband trading unit. "After a thorough review of our businesses, we have decided to take these charges to clear away issues that have clouded the performance and earnings potential of our core energy businesses," said Kenneth Lay in a statement.^[61] Some analysts were unnerved. "What's next?," asked David Fleischer at Goldman Sachs, an analyst called previously 'one of the company's strongest supporters' ^[62] asserting that the Enron management "lost credibility and have to reprove themselves. They need to convince investors these earnings are real, that the company is for real and that growth will be realized".^[63]

Additionally Enron asserted that the broadband unit alone was worth $35 billion, a claim also mistrusted. "I don't think anyone knows what the broadband operation is worth," said Todd Shipman, an analyst at Standard & Poor's.^[64]

On October 22, 2001, the share price of Enron fell to $20.65, down $5.40 in one day, following the SEC's announcement that it was investigating several suspicious deals struck by Enron, pronouncing "some of the most opaque transactions with insiders ever seen".^[65] Attempting to explain the billion dollar charge and calm investors, Enron's disclosures spoke of "share settled costless collar arrangements," "derivative instruments which eliminated the contingent nature of existing restricted forward contracts," and strategies that served "to hedge certain merchant investments and other assets." Such puzzling phraseology left many analysts feeling ignorant about just how Enron ran its business.^[66]

Regarding the SEC investigation, chairman and CEO Lay said, "We will cooperate fully with the S.E.C. and look forward to the opportunity to put any concern about these transactions to rest."^[67]

[edit] Liquidity concerns

Concerns about Enron's liquidity prompted Lay to participate in a conference call on Oct. 23, in which he attempted to reassure investors that the company's cash resources were ample and no further "one-time charges" loomed. Secondly, Lay adamantly insisted there were no improprieties regarding Enron's transactions with partnerships run by Andrew Fastow. Lay emphasized his support for Fastow.^[68] David Fleischer, the analyst at Goldman, was again skeptical, telling Lay and Fastow, "There is an appearance that you are hiding something." Nevertheless, Fleischer persisted in recommending the stock, arguing that he didn't "think accountants and auditors would have allowed total shenanigans."^[69] Lay also attempted to reassure the conferees by stressing that all of Enron's financial and accounting maneuvers had been scrutinized by their auditor, Arthur Andersen. After several questioners pressed the issue, Lay stated Enron management would "look into providing" more detailed statements for the end of better understanding the company's relationship with the special entities as those run by Fastow.^[70]

Two days later, on October 25, 2001, despite his reassurances days earlier, Kenneth Lay removed Fastow from his position. Enron's stock was now trading at $16.41, having lost half its value in a little over a week. "In my continued discussions with the financial community, it became clear to me that restoring investor confidence would require us to replace Andy as C.F.O.," said Lay in the statement announcing Fastow's exit.^[71] However, with Skilling and Fastow now both departed, some analysts feared that shedding light on the company's practices would be made all the more difficult.^[72]

On October 27 the company began buying back all its commercial paper, valued at around $3.3 billion, in an effort to keep investors from fearing about Enron's supply of cash. Enron financed the re-purchase by depleting its lines of credit at several banks. While the company's debt rating was still considered investment-grade, its bonds were trading at levels slightly below, making future sales problematic.^[73]

As October 2001 came to a close, serious concerns were being raised by some observers regarding Enron's possible manipulation of accepted accounting rules; however, some claimed analysis was impossible based on the incomplete information provided by Enron.^[74]

Some now openly feared that Enron was the new Long-Term Capital Management, the hedge fund whose collapse in 1998 threatened systemic failure in the international financial markets. Enron's tremendous presence worried some about the consequences of Enron's possible collapse.^[75] Enron executives were tight-lipped, accepting questions in written form only.^[76]

[edit] Credit rating downgrade

The central short-term danger to Enron's survival at the end of October 2001 seemed to be its credit rating. It was reported at the time that Moody's and Fitch, two of the three biggest credit-rating agencies, had slated Enron for review for possible downgrade.^[77] Such a downgrade would force Enron to issue millions of shares of stock to cover loans it had guaranteed, a move that would bring down the value of existing stock further.

Additionally, all manner of companies began reviewing their existing contracts with Enron, especially in the long term, in the event that Enron's rating were lowered below investment grade, a possible hindrance in future transactions.^[78]

Analysts and observers continued their chorus of complaints regarding Enron's difficulty or impossibility of properly assessing a company whose financial statements were so mysterious. Some feared that no one at Enron apart from Skilling and Fastow could completely explain years of mysterious transactions. "You're getting way over my head," said Ken Lay in late August 2001 in response to detailed questions about Enron's business, a reaction that worried analysts.^[79]

On October 29, 2001, responding to growing concerns that Enron might in the short-term have insufficient cash on hand, the news spread that Enron was seeking a further $1–2 billion in financing from the banks.^[80]

The next day, as feared, Moody's lowered Enron's credit rating, or senior unsecured long-term debt ratings, to Baa2, two levels above so-called junk status, from Baa1. Standard & Poor's also lowered their rating to BBB+, the equivalent of Moody's rating. Moody's also warned that it might downgrade Enron's commercial paper rating, the consequence of which might be preventing the company from finding the further financing it sought to keep solvent.^[81]

November began with the disclosure that the SEC was now pursuing a formal investigation, prompted by questions related to Enron's dealings with "related parties". Enron's board also announced that it would commission a special committee to investigate the transactions, headed by William C. Powers, the dean of the University of Texas law school. "We welcome this request" to cooperate with the SEC, said Kenneth Lay in a statement.^[82] The next day, an editorial in the New York Times called for an "aggressive" investigation into the matter.^[83]

On November 2, 2001 Enron succeeded in securing an additional $1 billion in financing from crosstown rival Dynegy, but the news was not universally admired in that the debt was secured with the company's valuable Northern Natural Gas and Transwestern Pipeline.^[84]

[edit] Proposed buyout by Dynegy

Sources claimed that Enron was planning to explain its business practices more fully within the coming days, as a confidence-building gesture.^[85] Enron's stock was now trading at around $7, as investors worried that the company would not be able to find a buyer.

After it received a wide spectrum of rejections, Enron management apparently found a buyer when the board of Dynegy, another energy trader based in Houston, voted late at night on November 7 to acquire Enron "at a fire-sale price"^[86] or about $8 billion in stock. Chevron Texaco, which at the time owned about a quarter of Dynegy, agreed to provide Enron with $2.5 billion in cash, specifically $1 billion up front and the rest when the deal was completed. Dynegy would also be required to assume nearly $13 billion of debt, plus any other debt hitherto occluded by the Enron management's secretive business practices^[87], possibly as much as $10 billion in "hidden" debt.^[88] Dynegy and Enron confirmed their deal on November 8, 2001.

Commentators remarked on the different corporate cultures between Dynegy and Enron, and on the "straight-talking" personality of the CEO of Dynegy, Charles Watson.^[89] Some wondered if Enron's troubles had not simply been the result of innocent accounting errors.^[90] By November, Enron was asserting that the billion-plus "one-time charges" disclosed in October should in reality have been $200 million, with the rest of the amount simply corrections of dormant accounting mistakes.^[91] Many feared other "mistakes" and restatements might yet be revealed.^[92]

November 9, 2001 brought with it another major correction of Enron's earnings with a reduction of $591 million over the stated revenue of years 1997-2000. The charges were said to come largely from two special purpose partnerships, called "JEDI" and "Chewco". The corrections resulted in the virtual elimination of profit for fiscal year 1997, with significant reductions every other year. Nevertheless Dynegy was reported to have not lost interest in purchasing Enron despite this disclosure.^[93] Both companies were said to be anxious to receive an official assessment of the proposed sale from Moody's and S&P (considered by some a "do or die"^[94] deal for Enron) presumably to understand the effect on Dynegy and Enron's credit rating the completion of any buyout transaction. In addition, concerns were raised regarding antitrust regulatory hurdles leading to possible divestiture, along with what to some observers were the radically different corporate cultures of Enron and Dynegy.^[95]

Nevertheless both companies pushed aggressively for the deal, and some observers were hopeful; Charles Watson was praised for his vision in attempting to create the biggest presence on the energy market in one fell swoop.^[96] "We feel [Enron] is a very solid company with plenty of capacity to withstand whatever happens the next few months," said Watson at the time.^[97] One analyst called the deal "a whopper [...] a very good deal financially, certainly should be a good deal strategically, and provides some immediate balance-sheet backstop for Enron."^[98]

Credit issues were becoming more critical, however. Around the time the buyout was made public, Moody's and S&P both lowered Enron's rating to just one notch above junk status. Were the company's rating to fall below investment-grade, its ability to trade might be severely limited subsequent to a curtailment or elimination of its credit lines with competitors.^[99] In a conference call, S&P affirmed that, were Enron not to be taken over, S&P would cut its rating cut to low BB or high B, ratings "not even at the high end of junk".^[100] Furthermore many traders had limited their doing business with Enron, or stopped altogether, fearing more bad news. But Watson again attempted to re-assure, affirming during a presentation to investors in New York that there was "nothing wrong with Enron's business."^[101] He also acknowledged that remunerative steps (in the form of more stock options) would have to be taken to redress the animosity of many Enron employees for management after it was revealed that Lay and other top officials had sold hundreds of millions of dollars worth of stock in the months leading up to the crisis.^[102] The situation was not helped by the disclosure that Kenneth Lay, his "reputation in tatters"^[103], stood to receive a payment of $60 million as a change-of-control fee subsequent to the Dynegy acquisition, and this while many Enron employees had seen their retirement accounts, which were largely based on Enron stock, decimated as the price fell 90% in a year. "We had some married couples who both worked who lost as much as $800,000 or $900,000," said an official at a company owned by Enron. "It pretty much wiped out every employee's savings plan."^[104]

Watson assured investors that the true nature of Enron's business had been made clear to him: "We have comfort there is not another shoe to drop. If there is no shoe, this is a phenomenally good transaction," he said at the time.^[105] Watson further asserted that Enron's energy trading part alone was worth the price Dynegy was paying for the whole company.^[106]

By mid-November, Enron announced it was planning to sell about $8 billion worth of underperforming assets, along with a general plan to reduce its scale for the sake of financial stability.^[107]

On November 19, 2001 Enron disclosed to the public further evidence of its critical state of affairs. Most pressingly that the company was facing debt repayment obligations in the range of $9 billion by the end of 2002. Such debts were "vastly in excess" of its available cash.^[108] Also, the success of measures to preserve its solvency were not guaranteed, specifically as regarded asset sales and debt refinancing. "An adverse outcome with respect to any of these matters would likely have a material adverse impact on Enron's ability to continue as a going concern," said Enron in a statement.^[109]

Two days later, on November 21, Wall Street was expressing serious doubts that Dynegy would proceed with its deal at all, or would seek to radically renegotiate. Furthermore Enron revealed in a 10Q filing that almost all the money it had recently borrowed for purposes including buying its commercial paper, or about $5 billion, had been exhausted in just 50 days. Analysts were unnerved at the revelation, especially since Dynegy was reported to also have been unaware of Enron's rate of cash use.^[110]

In order to walk away from the proposed buyout, Dynegy would need to legally demonstrate a "material change" in the circumstances of the transaction; as late as November 22, sources close to Dynegy were skeptical that the latest revelations constituted sufficient grounds.^[111]

The SEC announced it had filed civil fraud complaints against Arthur Andersen LLP, Enron's auditor.^[112] A few days later, sources claimed Enron and Dynegy were now actively renegotiating the terms of their arrangement.^[113] Dynegy now demanded Enron agree to be bought for $4 billion rather than the previous $8 billion. Observers were reporting difficulties in ascertaining whether or which of Enron's operations, if any, were profitable. Reports described an en masse shift of business to Enron's competitors for the sake of risk exposure reduction. Finally, a new report from Moody's made Wall Street nervous.^[114]

[edit] Bankruptcy

Enron's headquarters in Downtown Houston was leased from a consortium of banks who had bought the property for $285 million in the 1990s. It was sold for $55.5 million, just before Enron moved out in 2004. ^[115]

On November 28, 2001, Enron's two worst outcomes came true. Dynegy Inc. unilaterally disengaged from the proposed acquisition of the company and Enron's credit rating fell to junk status. The company, having very little cash with which to run its business, let alone satisfy enormous debts, imploded. Its stock price fell to $0.61 at the end of the day's trading. "Enron is now shorthand for the perfect financial storm," wrote one editorial observer.^[116]

Systemic consequences were felt, as Enron's creditors and other energy trading companies suffered the loss of several percentage points. Some analysts felt Enron's failure highlighted the risks of the post-September 11 economy, and encouraged traders to lock in profits where they could.^[117]

The question now became determining the total exposure of the markets and other traders to Enron's failure. Early figures put the number at $18.7 billion. "We don't really know who is out there exposed to Enron's credit," said one adviser. "I'm telling my clients to prepare for the worst."^[118]

Enron was estimated to have about $23 billion in liabilities, both debt outstanding and guaranteed loans. Citigroup and JP Morgan Chase in particular appeared to have significant amounts to lose with Enron's fall. Additionally, many of Enron's major assets were pledged to lenders in order to secure loans, throwing into doubt what if anything unsecured creditors and eventually stockholders might receive in bankruptcy proceedings.^[119]

Enron's European operations filed for bankruptcy on November 30, 2001, and it sought Chapter 11 protection in the U.S. two days later on December 2. At the time, it was the biggest bankruptcy in U.S. history, and it cost 4,000 employees their jobs.^[120][121]

The day that Enron filed for bankruptcy, Enron's workers were told to pack up their belongings and were given 30 minutes to vacate the building.^[122] Around 15,000 employees held 62% of their savings in Enron stock, purchased at $83.13 in early 2001; when it went bankrupt in October 2001, Enron’s stock plummeted to $0.10.^[123]

[edit] Trials

Kenneth Lay, the former Chairman of the Board and Chief Executive Officer and Jeffrey Skilling, former Chief Executive Officer and Chief Operating Officer, went on trial for their part in the Enron scandal in January 2006. The 53-count, 65-page indictment covers a broad range of financial crimes, including bank fraud, making false statements to banks and auditors, securities fraud, wire fraud, money laundering, conspiracy and insider trading. U.S. District Judge Sim Lake had previously denied motions by the defendants to hold separate trials and to move the case out of Houston, where the defendants argued the negative publicity surrounding Enron's demise would make it impossible to get a fair trial.

Lay pleaded not guilty to the eleven criminal charges. Lay stated that he was misled by those around him. At the time of his death in July, 2006 the U.S. Securities and Exchange Commission (SEC) had been seeking more than $90 million from Lay in addition to civil fines.

The case surrounding Mrs. Linda Lay is a difficult one. Mrs. Lay sold roughly 500,000 shares of Enron ten minutes to thirty minutes before the information that Enron was collapsing went public on November 28, 2001.^[124]

On January 13, 2006 lobbyist William "Art" Roberts pleaded guilty to impersonating Senate staff members during the investigation. Roberts was hired by a German bank in June 2004 to get a letter from a Senate subcommittee stating the bank had done their due diligence investigating the Enron collapse, as part of the bank's defense in a suit filed against it by a London bank. ^[125]

Although Michael Kopper worked for Enron for over seven years before the scandal became public, he was always under the radar. Kenneth Lay, Enron CEO, did not know of Kopper even after the company's bankruptcy. Kopper was able to keep his name anonymous in the entire affair, as the spotlight remained on Fastow throughout the entire affair.^[126]

On May 25, 2006, the jury in the Lay and Skilling trial returned its verdicts. Skilling was convicted of 19 of 28 counts of securities fraud and wire fraud and acquitted on the remaining nine, including charges of insider trading. He was sentenced to 24 years, 4 months in prison. Lay was convicted of all six counts of securities and wire fraud for which he had been tried, and he faced a total sentence of up to 45 years in prison. ^[127] Lay died on July 5, 2006, before sentencing was scheduled. On July 12, 2006, a potential Enron witness scheduled to be extradicted to the US, Neil Coulbeck, was found dead in a park in north-east London.[4] The US case alleges that Coulbeck and others conspired with former Enron CFO Andrew Fastow.[5] All told, sixteen people pleaded guilty for crimes committed at the company, and five others, including four former Merrill Lynch employees, were found guilty at trial. Eight former Enron executives testified, the star witness being Fastow, against Lay and Skilling, his former bosses. ^[128] Another was Kenneth Rice, the former chief of Enron Corp.'s high-speed Internet unit, who cooperated and whose testimony helped convict Skilling and Lay. In June 2007, he received a 27 month sentence.^[129]

[edit] Aftermath

Between December 2001 and April 2002, the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial Services held numerous hearings about the collapse of Enron and related accounting and investor protection issues. These hearings and the corporate scandals that followed Enron led to the passage of the Sarbanes-Oxley Act on July 30, 2002.^[130]

The main provisions of the Sarbanes-Oxley Act are as follows:

• Section I: Establishment of the Public Company Accounting Oversight Board to establish standards related to the preparation of audit reports;
• Section II: Restrictions on public accounting firms that require public accounting firms not provide any non auditing services contemporaneously with auditing;
• Section III: Provisions for independence of audit committee members (subsection 301), executive certification of financial reports (subsection 302), and forfeiture of certain bonuses to executives upon financial restatements (subsection 304);
• Section IV: Enhanced financial disclosure of firms’ relationships with unconsolidated entities.^[131]

The numerous cases of accounting irregularities and corporate misconduct also led to changes to the stock exchanges’ regulations. On February 13, 2002, in the midst of the senate and house investigation of Enron, the SEC called for the major stock exchanges to review their governance requirements. On June 6, 2002, the New York Stock Exchange announced the governance proposal recommended by its board committee. The SEC approved the proposals in November 2003. The main provisions of the final NYSE proposal are:

1. All firms must have a majority of independent directors.
2. Independent directors must comply with an elaborate definition of independent directors.
3. The compensation committee, nominating committee, and audit committee shall consist of independent directors.
4. All audit committee members should be financially literate. In addition, at least one member of the audit committee is required to have accounting or related financial management expertise.
5. In addition to its regular sessions, the board should hold additional sessions without management.^[132]

[edit] Notes