Enron Scam: The biggest scam in the history of America

Introduction

EnronScam is the name of an institutional fraud committed by a corporation Enronregistered in the United States of America. The scam was a result of faulty accounting ofthe 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 : Scam

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.

TheSEC had begun an inquiry into Enron and the partnerships. After a week ofinquiry, a full investigation was launched against the company. The SEC evenissued a cease and desist order against Anderson regarding security violations insome other company. When Anderson wasasked to provide the Enron audit documents, it couldn’t comply. Variouscompanies which were audited by Anderson were under the scrutiny of SEC forfraudulent 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 ofdocuments which also amounted to obstruction of justice, a felony under thefederal laws of the USA. Arthur Anderson lost its license to engage in publicaccounting when the Justice Department declared it guilty. Three years later,the Supreme Court overturned the judgment but the firm had lost all itsclientele by then. Soon, the company vanished.

The Scam

Enron scam is the name for theevents that led to the bankruptcy of the US energy, commodities and servicescompany Enron and dissolution of its auditor Arthur Anderson LLP. Enron heldmore than $60 billion worth of assets, when it abruptly filed for the biggestbankruptcy in the history of the USA leaving long lasting repercussions on thefinancial world.

To understand the scam in detail,we must understand the two concepts of market system, the Bullish and theBearish system. The Bear system is more into trial and error. The investmentsand capitalisation is on daily level. The fluctuations are also regular andvery 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 Bullishsystem of market and grew overnight. The company was ready to create a market foranything and everything in which anyone was willing to trade. It madederivative contracts for a wide range of commodities like electricity, coal,paper, steel and even weather reporting. The company also invested in buildinga broadband telecommunication network to facilitate high speed trading. Thiswas a period of boom for the economy when there was a market for everycommodity. Soon, the system changed. The company was facing increasedcompetition and its profits shrank rapidly. To compete, and to avoid thepressure from shareholders, the company began a practice of dubious accountingknown as ‘mark-to-market’ under which the company accounts showed the futuregains from trading contracts into current income statements, thus fooling theinvestors by showing higher profits than they actually were. The troubledoperations of the company were transferred to Special Purpose Entities (hereinafterreferred as ‘SPEs’), to limit the partnerships created with outside parties.Enron used the SPEs as a dump site for its troubled assets. Transferring theassets to SPEs meant that the same need not be shown in company’s books, whichmade 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 aconsultant for the company. This was seen as a fraud and malicious practiceagainst the investors who were not told the truth before they planned to investin the company.

Also Read Issue of Shares in a Private Company

Thematter came into notice when various analysts began to dig into the financialstatements of Enron. An internal investigation took place, headed by the VicePresident of the company, which was soon followed by an official investigationby the SEC analysing the transactions between Enron and the SPEs. Soon after,Enron filed for bankruptcy . The Enron executives were indicated on a varietyof 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

Enrongrew manifold in the short time span of 20 years. But, it also saw the most abruptdownfall ever by going for bankruptcy from a market capitalisation of $60billion in a year. The reasons for itsdownfall were many, mainly that the financial statements of the company wereconfusing the shareholders and analysts. Its business model was very complexthat most people could not understand, the company was falling into manyunethical practices. The company even used its accounting limitations tomisrepresent its earnings and modify the balance sheet to indicate favourableperformance. The company kept finding ways to hide its debt till the extentthat the company went into total losses. The company’s officers prepared suchbalance sheets, complex financial structures and bewildering deals that no onecould understand them, let alone wishing to invest. Therefore, the company sunkinto losses and had to go for bankruptcy.

Repercussions

Thewhole scam was a huge setback for America. To avoid the slightest possibilityof such an incident in future, new regulations and legislations were introducedto improve the accuracy of financial reporting of public companies. TheSarbanes-Oxley Act, 2002 also called as “Public Company Accounting Reform andInvestor Protection Act” and “Corporate and Auditing Accountability,Responsibility, and Transparency Act” was passed by the US Senate whichprovides for a set of enlarged requirements for all US Public Company Boardsand managements relating to destroying, altering or fabricating records ininvestigations and attempting to defraud shareholders. The Act also increasedthe accountability of auditing firms, in order to make them unbiased andindependent 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 infraud and the auditors from supporting the same. The Act also prohibitedauditing firms to act as a consultant for the same clients as well as hadhappened in the present case.

Timeline of Events

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

Lessons Learnt from Enron Scandal

The following lessons can be learntfrom the scam which shook the Wall Street scam majorly-

Thereshould be a healthy corporate culture in a company. The executives of Enronbelieved Enron was best at everything and jumped into any possible new arena.The shareholders were overly optimistic. Hiding the losses of company in orderto protect the name and reputation wasn’t a great idea.
Amore holistic system is required for supervision of the company byshareholders, so that the executives are under a constant scrutiny of theshareholders.
Thegovernment needs to make more stringent norms regarding public companies astheir downfall hits the entire economy of the country, like in the presentcase.
Theapproval 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 hidethe 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 partof government as it hides the major accounts of the company.
This case is the bestexample of antithesis of ethics. A company is such an organisation where thereare multiple possibilities of fraud and demeanour. It is of utmost importanceto follow business ethics and be loyal to each other for all employees of thecompany. In the present matter, the company officials defrauded their ownemployees by hiding the accounts of the company from them.

Potential Solution

While going through news reports,we find that the cases of financial scam have grown manifold over the last fewyears. This has been one of the most deterring factors for the people withlesser knowledge about this sector from investing their capital andcontributing in the growth of a country’s economy. To bring about a decline inthis culture of corporate scams, the following systematic changes need to bebrought-

The law for protectionof Whistle Blowers is imperative. More people will come forth to giveinformation about this scam if they are given assurance of their protection.
The regulating agenciesinvolved in these cases should be provided with greater autonomy and lesspolitical influence.
An essential judicialreform to provide for fast disposal of such matters, so that the consequencesare severe and immediate.

Conclusion

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