Enron Scandal: The Lessons To Be Learnt

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The main perpetrators in Enron’s fraud scheme were Kenneth Lay, Jeffrey Skilling, Andy Fastow, Louis Borget, Thomas Mastroeni, Lou Pai, and Tim Belden. In addition, the accounting firm Arthur Anderson, the law firm Vinson and Elkins, and various banks were also involved.

Kenneth Lay was the founder, chairman, and CEO of Enron. He convinced shareholders to invest in the company by making false public statements about the company’s performance. When he realized that the company was failing, he sold his stock while at the same time told his employees to purchase more. While Enron’s stock was plummeting before it declared bankruptcy on December 2, 2001, the top executives were able to sell $1 billion in stocks, while the employees’ stocks were frozen so they could not sell them.

Enron hired Jeffrey Skilling in 1990 and he became Chief Operating Officer in 1997. He then became CEO after Ken Lay moved to chairman. Skilling helped create the natural gas commodities market where Enron would trade on natural gas as if it were a stock or bond. Skilling used mark to market accounting (MTM), which allowed Enron to book potential future profits no matter how much money was actually earned. Arthur Anderson and the SEC approved the use of MTM accounting, which enabled Enron to manipulate its earnings and pay its executives’ bonuses based on reported MTM accounting profits.

The first Enron scandal was the 1987 Valhalla Scandal beginning, which involved two oil traders, Louis Borget, Enron Oil’s president, and Thomas Mastroeni, Enron Oil’s treasurer. They would bet on whether the price of oil would rise or fall and were always accurate in their prediction, which was suspicious because nobody is always correct. They also set up offshore accounts and kept two sets of books, so they could falsely show that the oil division was making a profit year after year. Nobody was able to figure out who owned the offshore accounts. After the board received an anonymous tip that Borget embezzled more than $3 million and deposited it into his personal bank account, auditors were brought in and notified Kenneth Lay of Borget and Mastroeni’s fraudulent schemes. Because these two traders were making Enron so much money, Lay did nothing about it.

Andy Fastow was the CFO of Enron who covered up Enron’s debts and losses using structured finance to keep the stock price high. Fastow created hundreds of companies to hide Enron’s $30 billion debt so it would appear as if Enron was more profitable than it actually was. Lou Pai was the CEO of Enron Energy Services. He charged personal expenses, including strippers, to Enron’s expense account and used the corporate jet for personal use. Although he made $100 million while at Enron and around $250 million from selling stocks when he left Enron in 2001, his division had lost almost $1 billion. This loss was hidden using mark to market accounting. He also used mark to market accounting to value current energy prices based on expected future prices. Tim Belden, who ran Enron’s west coast’s trading desk, took advantage of California’s deregulated energy market. He would create artificial shortages of energy by creating blackouts throughout California, which through the principles of supply and demand, would increase energy prices. He also devised a plan where Enron would export California’s energy to another state and then buy it back at inflated prices to drive up the price of energy sold to California residents.

The groups that were supposed to advise Enron were also involved in its fraud. Accounting firm Arthur Anderson did not do their due diligence while auditing Enron. They would issue unqualified opinions when they were aware that the financial statements contained material misstatements. They also obstructed justice by destroying documents when the SEC started their investigation. In addition, the law firm Vinson and Elkins, along with Arthur Anderson, helped Enron hide hundreds of millions of dollars of debt by creating partnerships that were not reported and provided no oversight into this corrupt behavior. Lastly, various banks invested millions in Enron and got involved in a few of its shady deals. For example, in 1999, Merrill Lynch pretended to purchase three Nigerian power barges from Enron, when in reality, it was actually a loan that increased Enron’s net income. Since Enron paid Merrill Lynch back five months later, it was basically a loan.

There were many red flags throughout Enron’s existence that are typically associated with fraud. During the Valhalla Scandal, Borget and Mastroeni were always able to correctly predict if the price of oil would rise or fall. By manipulating the books and setting up offshore accounts, they were able to show that the company was continually making a profit, which is inconceivable. Offshore accounts are usually set up by companies to hide their finances, and it was suspect that nobody was able to figure out who owned the offshore accounts. In addition, it did not make sense that blackouts kept occurring in California when there was plenty of power available. Another red flag was that management was not willing to discuss Enron’s financials and fully explain its finances. Enron traded at a 60 price to earnings ratio, which was more than three times higher than other companies in its industry. Lastly, it was suspicious that Jeffrey Skilling unexpectedly resigned on August 14th, 2001 six months after he became CEO and only a few months before Enron declared bankruptcy on December 2nd.

Enron’s frauds were detected from a number of sources. First, in 1987 during the Valhalla Scandal, Enron’s board received an anonymous tip that Louis Borget put more than $3 million of corporate funds into his personal bank account. On March 5th, 2001, Forbes published an article called “Is Enron Overpriced” by Bethany McLean which brought attention to misstatements in Enron’s financial statements. In August 2001, Sharron Watkins, an Enron VP, became an anonymous whistleblower by writing a detailed letter to Ken Lay about Enron’s accounting irregularities and illegal activity, including Fastow’s business partnerships. Ultimately, a Wall Street Journal Article written in 2001 questioning Enron’s deals started an SEC investigation. The results of the Enron scandal contributed to the passing of the Sarbanes Oxley Act of 2002. Had the act been around sooner, Enron’s fraud could possibly have been prevented or detected sooner.

Enron’s frauds started in 1987 with the Valhalla scandal and continued until it declared bankruptcy in 2001. At its highest point, Enron was worth $70 billion, and its stock was trading at around $90 per share and then within a year it declared bankruptcy and its stock dropped to $.26 per share. As Enron was making $1-2 million per day taking advantage of California’s deregulated energy market, California ultimately lost $30 billion. Lou Pai left Enron with the most amount of money, but did not face any federal charges.ii Louis Borget was sentenced to one year in jail and Tom Mastroeni was sentenced to two years of probation and 400 community service hours. Tim Belden pleaded guilty to conspiracy to commit wire fraud and was sentenced to two years of court-supervised probation. Andy Fastow pleaded guilty to conspiracy to commit wire fraud. He was sentenced to ten years of jail and had to sacrifice $23 million in assets. Jeffrey Skilling convicted on 19 counts of conspiracy fraud and insider trading and was sentenced to 24 years in prison, which was reduced to 10. $40 million of his assets were distributed to Enron’s victims. Ken Lay pleaded guilty to conspiracy fraud, but he died before being sentenced. Arthur Anderson was found guilty of obstructing justice by destroying Enron’s documents during an SEC investigation. Enron’s employees were affected by Enron’s frauds as thousands of employees lost their jobs, health care, retirement funds, and savings. Employees lost $1.2 billion in retirement funds and retirees lost $2 billion in pension funds.

An entity should have preventive tools and techniques in place to prevent future similar frauds. The Sarbanes Oxley Act of 2002 was passed in response to Enron and various other accounting scandals. The act was created to protect investors by setting new auditing standards and protection for whistleblowers. If Arthur Anderson had to follow the Sarbanes Oxley Act, they would not have signed off on materially misstated financial statements. A public company is now required to have internal controls over financial reporting and the COSO Framework is generally recommended to establish and implement controls. One of the components of the COSO Framework is the control environment, which states that an entity should have a commitment to ethics and integrity by developing a code of ethics. Enron had a cutthroat culture where employees were encouraged to do whatever was needed to succeed. They had a “rank and yank” policy where employees would evaluate each other annually and the bottom 15% would be fired. Therefore, employees took risks needed to succeed and covered up losses using MTM accounting. Had Enron had a code of ethics that was appropriately demonstrated from management, fraudulent acts could have been prevented. The Sarbanes Oxley Act also created protection for whistleblowers, which could have led to employees coming forward about Enron’s fraud sooner without the risk of being fired. In addition, big corporate money should be taken out of politics. Ken Lay had a close relationship with and donated to President George W. Bush’s campaign. The president, in turn, prevented the California energy market from being regulated at the federal level, which benefited Enron’s scheme. Lastly, employees should be allowed to sell stock if executives can do so. This would have prevented Enron employees from losing their life savings due to Enron’s bankruptcy.

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