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The Prerequisites, Reasons And Consequences For Enron Scandal

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Overview

Energy corporation Enron was one of the largest players in corporate America. The company grew at a rapid state and was highly favoured by analysts and investors. Although Enron’s forecasts and financial reports for the late 1990s and early 2000s guaranteed stakeholders of continuous growth, this was not the case and it eventually played out to be the biggest accounting scandal in corporate America.

Recent changes in the company’s management have brought on a slew of accounting practices that deviated far from normal. Extremely complex transactions were created wherein other company executives and employees found it difficult to understand. The company’s executive team lacked leadership skills and competence to comprehend accounting principles. Conspiracy of Fools depicted Enron’s executives as power-hungry and thirsty for financial success. Many, including the CEO and president, were terribly fearful of incurring losses, disappointing stakeholders and not being an industry leader, that they were blindsided by all of the questionable transactions and practices transpiring within the organization. Kurt Eichenwald’s Conspiracy of Fools provides an in-depth description of how and why the largest scandal in corporate America materialized.

The Scandal

The book begins with a fraud which occurred prior to the big scandal that caused Enron’s bankruptcy. Executives Louis Borget and Thomas Mastroeni colluded to steal money from the company and redirect it to an offshore account. Reflecting on this event, then chief executive officer Ken Lay pledged that Enron will no longer engage in risks without understanding potential consequences. He assured employees that Enron’s credibility will not be questioned again. A similar instance to what caused Enron’s downfall, this event set the tone of the book.

The beginning of Jeffrey Skilling’s career at Enron also marked the start of the company’s downturn. Within a few weeks, Skilling had reorganized the company, reduced the number of executives, and changed seniority-based compensation to performance-based. This presented a motivation for employees to improve their performance by maximizing short-term earnings rather than long-term goals. Additionally, his desire for aggressive accounting and implementing mark-to-market allowed the company to recognize profits instantly, with any change in value recorded as a profit or loss. The use for mark-to-market was later stretched in order to meet the projections of financial analysts.

Skilling then hired Andrew Fastow, whom he became good friends with. Like Skilling, Fastow also had a liking for aggressive accounting. Using mark-to-market, Fastow became motivated to increase profitability in unconventional ways. This prompted him, along with Michael Kopper, to create special-purpose entities (SPE) with the intent of purchasing assets from Enron. These shell corporations essentially used Enron’s money to hide the company’s debts off its balance sheet, thus avoiding recording losses. Also, Fastow and Kopper found a loophole to avoid creating related-party transactions. They found outside investors that would provide 3% of the SPE capital, with the remaining 97% coming from the company. Fastow was able to create various SPEs but mostly focused on LJM and LJM2, which were named after his wife and two children. The employees, investors and other stakeholders were led to believe that the SPEs hedged the risks but in reality, they were using Enron’s money to finance the hedges. The two entities provided Fastow and his accomplices a steady cash flow, amounting to millions of dollars that were essentially stolen from Enron. On the books, Enron was shown to be making money off these transactions, which analysts and investors liked.

As the company grew, the superficial SPE transactions became bigger as well. Investors and analysts were pleased of the company’s financial state while the SPEs were keeping their debts off-the-books. However, not everyone was pleased. Finance journalist Bethany McLean was skeptical of Enron’s financials and wrote an article about the accuracy of the company’s stock price. Later in the book, whistleblower Sherron Watkins exposed the truth about the special-purpose entities to the company executives. She wrote a letter to Ken Lay describing how the SPEs did not make economic sense and her concerns about the viability of the company. However, it was not until months later that her concerns became public triggering an investigation by the Securities Exchange Commission (SEC).

Improper accounting eventually caused Enron to lose its credibility. The company’s stock price declined dramatically, their rating was downgraded, and no one wanted to engage in any form of transaction with them. In the end, Enron was filed for bankruptcy and its employees lost not only their jobs but also their retirement funds.

Key Players

Andrew Fastow

Fastow created a name for himself by creating special purpose entities as investment vehicles for Enron. He introduced the idea of Chewco as a way to increase investment value for the CALPERS. With the success of his SPE ideas, Fastow easily made his way up the corporate ladder into the position of the Chief Financial Officer. His newfound success in the company proved to be the cause of his downfall. His desire to rise to the top while secretly siphoning off millions of dollars made him a greedy yet smart man. He was, in fact, the reason why Enron was able to meet profit projections by investment analysts.

Throughout the book, Fastow created multiple SPEs, all intertwined with one another in some way. This was his genius idea to allow Enron to recognize revenues far ahead of the performance of obligations. Although Eichenwald did not directly state if Fastow was competent enough to perform his duties and responsibilities as the chief financial officer, it was alluded throughout the text that he was not very knowledgeable in the accounting field. This was exemplified when Fastow stated that he does not have any interest rate exposure, where in actuality, the net present value of Enron’s projections extremely dependent of interest rates. Additionally, those who did understand his complex SPE transactions knew that these were irregular accounting practices. Many believed that he was not qualified for the job as he lacked expertise, but Jeffrey Skilling seemed to have been blindsided by the deals that Fastow was establishing. Enron’s board of directors was also blindsided by Fastow’s skills, as proven by the fact that he was allowed to be managing partner of LJM2 whilst still acting as Enron’s chief financial officer. Every transaction designed by Fastow seemed to have been littered with unrealistic rationalizations. He normalized aggressive accounting, providing him the opportunity to stand out against everyone else due to the returns that resulted from this. This resulted in his colleagues praising him and his contributions to the company’s bottom line. Perhaps it is safe to allude that Fastow’s actions were not solely driven by financial gain, but also by increased popularity amongst his peers. This was proven on numerous occasions by the mere fact that Jeffrey Skilling approved the SPEs with very little analysis due to the fact that he had put so much trust in Fastow’s ability.

Next, Fastow was not suitable for a leadership position due to his constant desire to stay in power. A good leader will help employees develop their skills and promote those who are well-deserving. Andrew Fastow did the exact opposite. He rewards employees who naïvely helped him steal copious amounts of money from the company by endorsing them to the Performance Review Committee (PRC). Those who tried to go against him by telling him the flaws of his ideas were punished in various ways such as by being transferred, by not being given their deserved compensation, and more. Additionally, he pressured banks such as Merrill-Lynch to provide funding to Enron by threatening them to take their business elsewhere. Fastow knew he had the upper hand in negotiation due to the company’s current high ranking in the corporate world.

Jeffrey Skilling

Jeffrey Skilling’s character as portrayed in Conspiracy of Fools was rather interesting. Since his early days at the broadcasting station, Skilling found that he liked having control and being in charge. He was a bright consultant at McKinsey & Company, eventually becoming the youngest partner. Eichenwald’s iteration of Skilling’s early life before Enron paints a picture of his conceit. His need to be in command gave him the drive, which paved the way for his corporate success. However, this also proved to be his weakness as he was unable to accept shortcomings and negative outcomes.

Throughout the novel, Skilling’s character started off as strong and confident. He knew what he wanted and made sure that he reaped the benefits. Due to his intelligence, he also had a fondness for complicated and creative deals, specifically Fastow’s transactions. It seemed like Skilling only liked the savviness of the transactions but actually did not understand the accounting that were presented. He even fought with their consultants at Arthur Andersen & Co. regarding the proper accounting treatment, arguing for their way to increase the bottom line. His argument along with lack of comprehension of the accounting displays how he as the president, failed his duty to lead the company with integrity and professionalism, and also discredited his own reliability as a leader and as a representative of Enron.

Moreover, Skilling was very focused on constantly improving profits and neglected other traits that would have made him an effective leader. For instance, he appointed Rebecca Mark head of Azurix but did not attempt to be involved, or at least informed, about its operations and negative profits until it was too late. He essentially let billions of dollars slip through the company’s hands due to lack of oversight. Next, he trusted Andrew Fastow too much. Even if the two were good friends, there should have been a boundary between their casual, friendly relationship and their professional relationship. By putting too much trust in Fastow, Skilling again lacked oversight in the SPE transactions. He believed that Fastow was competent and trustworthy enough to manage interrelated companies, namely Enron and the LJM funds. He also signed his name on deals which he barely analyzed, just because his colleagues have signed it. As the company’s president, it is his duty to ensure that Enron is engaging in transactions that are not only beneficial to the company but also conform to accounting frameworks and government regulations. By not reviewing the details of the transactions carefully, Skilling ignored his due diligence which one could argue was his crime in the scandal that soon unfolded.

As the fraud started to reveal itself, Enron’s state as a company began to spiral down. Simultaneously, Skilling’s physical and mental well-being also began to decline. Eichenwald brilliantly interconnected the two, which emphasized the effects of the events. It is a vivid imagery of Skilling’s lost sense of control.

Michael Kopper

Michael Kopper served as Andrew Fastow’s right-hand man in the Chewco and LJM ordeals. As head of special projects, he proved to everyone that he has the creativity and the ability to create structured deals that would yield great returns. His character, as written by Eichenwald, was always trying to impress. He worked very closely with Fastow and ensured his constant satisfaction. This resulted in his assignment to manage the LJM funds.

Conspiracy of Fools illustrated Kopper’s unethical behaviour consistently throughout the text. For instance, he was able to disguise the related party transactions as arm’s length using his domestic partner’s name to secure the controlling stake of LJM thus resulting in Enron’s ability to book income. The book actually had very little description of the work that Kopper performed and only emphasized on the way he manipulated the books to yield steady earnings, as well as keep track of his and Fastow’s off-the-record cash flow. Through this, one can infer that Eichenwald wanted to show that even though Kopper is smart and qualified, his greed and inability to act ethically proved to be his downfall. In addition to that, his character seems to go against a recurring theme of power struggle. It was pointed out that Kenneth Lay, Enron’s CEO at the time, did not know who Kopper was, even after working with Fastow for several years and improving Enron’s financials. This was surprising since as a CEO, why would one not know who is contributing to the bottom line in such a profound way? His anonymity and willingness to let Fastow take all the credit shows his contentment of being on the sidelines, which perhaps is one of the reasons Fastow was drawn to work with him.

Jeffrey McMahon

Jeffrey McMahon was Enron’s treasurer, thus he reported to Andrew Fastow. His character is a juxtaposition of his superior’s. Soon after learning about LJM and the other SPEs, McMahon quickly figured out his views and ensured that his voice was heard. Presented with a dilemma, he decided to confront Fastow about the transactions he was creating and when this failed, he went to Jeffrey Skilling. However, as an inferior who was not involved in generating substantial superficial cash flows, McMahon’s voice remained unheard.

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McMahon’s opposition against LJM shows his courage and integrity, thus making him a key character in the novel. He was one of the few characters who were not blinded by money, greed and power. Consequently, he was also one of the few employees who saw Fastow’s tactics in closing deals between Enron and LJM. McMahon understood the wrongfulness of Fastow having control of the traders’ compensation and promotions while not being independent from LJM. He took a great risk to expose the underlying issues of the transactions and although it did not pay off in the end, he was still able to stand by his values which is admirable. Additionally, McMahon proved his leadership skills when he was endorsing his employees to the PRC. Unlike Fastow, he recognized the work and effort his employees exert, and made recommendations based on merit. He fought for equal treatment for his employees at the PRC meeting, which speaks volumes as to what type of leader he is—fair and principled.

Sherron Watkins

Sherron Watkins who formerly managed JEDI, became the Vice President of Corporate Development at Enron. Similar to Jeffrey McMahon, Watkins also found the accounting irregularities in relation to the SPEs. A strong-gutted accountant, she became Enron’s whistleblower who exposed the misconducts occurring behind-the-scenes.

While going through Enron’s assets, Watkins was bewildered by the Raptors, another SPE used for hedging. This prompted her to dig deeper and learn more about the transactions. The accounting irregularities and SPE transactions which lacked economic substance left her feeling troubled. This urged her to write a memo to Kenneth Lay outlining her concerns. Upon meeting with the CEO, she was assured that there will be further investigation done to address the issues brought up. Her letter also triggered the SEC investigation against Enron. Overall, Sherron Watkins did what no one else in the company wanted to do—expose the wrongfulness of the SPEs—thus making her an important character in the novel.

Shortcomings of Key Players, Regulatory Agencies and Auditors

Key Players

The fraud at Enron occurred due to lack of proper checks and balances of the executive team. As such, the key players were abusive of the power that came with their job titles. In particular, Andrew Fastow took advantage of the fact that his colleagues and superiors saw him as a trustworthy individual. By not complying with securities regulations and accounting frameworks, he caused immeasurable damages to Enron. Specifically, the transactions he created made Enron appear financially sound, even though it was not. As a result, investors and analysts were misled and faithful representation of the financial statements was not met. This also resulted in credit rating agencies publishing an undeserved high credit rating for Enron. Additionally, Fastow used his power to threaten banks if they did not provide financing for Enron and LJM. This provided Enron with additional liquid assets that superficially improved their financials. In the end, Andrew Fastow’s actions seemed to have pushed the company more towards bankruptcy.

Next, Jeffrey Skilling’s actions also contributed to the fall of Enron. When he first started at Enron, he pushed for mark-to-market accounting which allowed them to realize profits prior to performing their obligation. This also provided Fastow with the idea of aggressive accounting. Stemming from this were the LJM deals spearheaded by Fastow. Skilling’s faulty actions were approving the deals without properly analyzing them, as well as disregarding the conflict of interest between Fastow’s roles in both companies, which he had noted early on. Moreover, he failed his duty as an executive by not confronting the secrecy surrounding the SPEs. He made minimal inquiries regarding these entities and only saw the end result of each transaction: Enron booking profits. In addition, he also failed his duty as the Chief Financial Officer by emphasizing stocks and ignoring current assets. In particular, no one at the company tracked the cash balance. Everyone focused on maintaining the high stock price, which undeniably was a factor in the turmoil. All in all, Jeffrey Skilling’s actions as the CFO seemed to have contributed to Enron’s deterioration.

Third, Ken Lay proved to also have been a factor in the scandal. At the beginning of the novel, Lay promised that Enron’s integrity will never be questioned again after the Borget-Mastroeni scandal. However, future events showed that Lay failed to keep this promise. When Fastow proposed to head up LJM to transact with Enron, there was a lack of probing on Lay’s end. Instead, he quickly supported it and took it to the board of directors for approval. Furthermore, similar to Skilling, he also did not confront the secrecy surrounding the SPEs. He was a supporter of these entities and their transactions with Enron, which consequently allowed the board to have confidence in them. Lay, just like the other executives, focused too much on profitability. All things considered, Ken Lay was not able to ensure as the CEO that he was steering the company in the right direction.

Lastly, Sherron Watkins was labelled as Enron’s whistleblower and praised for her courage. However, one can criticize that she still had shortcomings in her role as the one who blew the whistle. Upon first learning about the SPE transactions, Watkins knew something was wrong and she decided to write Ken Lay a letter. When the letter became known and she was told that the issue was being investigated, she did not follow up. It also took a long time for the letter to become public which triggered the SEC investigation. Thus, one may ask why she did not file a report with the SEC sooner or why she had not contacted the government. In addition, when Jeffrey McMahon replaced Fastow, the first thing she did was email him about what she wanted—new job title and better compensation. This leads one to believe that she ultimately had a personal motive which was self-promotion. Therefore, even the whistleblower, Sherron Watkins, had shortcomings in the Enron scandal.

Regulatory Agencies

In Conspiracy of Fools, the main regulatory agency at play was the SEC. Although they were not a big part of the novel, they still played a role in the scandal. Firstly, the SEC approved Jeffrey Skilling’s mark-to-market accounting. As the main regulatory body, the SEC should have known the risks of being able to manipulate financial statements using mark-to-market. Particularly, mark-to-market in the energy industry was abnormal which meant a lack of available data for comparability. Even though this was the case, the SEC never followed up on Enron to check if they were reporting accurately. Eichenwald seemed to not have information regarding the SEC’s actions post approval which leads one to believe that the SEC did nothing. Furthermore, during the multi-year financial statement manipulations, Enron was able to greatly inflate its profits. They were also able to do this without any inquiry or examination from the SEC. It is important to note that the SEC gets information about problems and irregularities from investors and analysts via market signalling . However, when analysts were starting to become skeptical about Enron’s financial statements, such as the conference call between Skilling and analysts, the SEC was unable to pick up on the clues. This resulted in a delay in the commencement of investigation, which occurred after the whistleblower letter was publicized.

Auditors

Another party that displayed shortcomings was Enron’s auditors, Arthur Andersen & Co. Their main fault as portrayed throughout the novel is overlooking the errors brought upon by creative accounting. Essentially, they were unable to sustain their duty of care as Enron’s auditors and consultants by failing to comply with the Generally Accepted Accounting Principles (GAAP) and the respective standards for auditing and consulting. This was seen when Arthur Andersen & Co. approved the related-party transactions between Enron and the SPEs. Another failure was when Arthur Andersen partner David Duncan ordered the shredding on Enron documents amidst the SEC investigation. This resulted in the destruction of potential evidence that the regulators could have used against Enron. Thirdly, Arthur Andersen still signed off on non-arm’s length deals even after concerns were brought up. Sherron Watkins expressed her concerns about the economic substance of the SPEs. After Enron executives consulted with their lawyers at Vinson & Elkins (V&E), they were provided with a conclusion that indicated no further investigation was necessary. Arthur Andersen’s fault was not verifying the appropriateness of V&E’s statement prior to signing off. Lastly, David Duncan failed to properly warn Enron of fraud. The risk-management executives at Arthur Andersen ran FIDO, a fraud detection program, on Enron’s financials and discovered a red alert which meant a fraud warning. Duncan and his superiors were alerted yet this issue was not addressed. Overall, Arthur Andersen & Co. breached its duty of care to Enron which contributed to its downfall.

Steps to Avoid Recurrence

The fall of Enron can be attributed to the various people listed in the prior section. Due to the enormity of the scandal, it is important to determine measures that will prevent the next Enron. These can be categorized into Regulatory Agency, Sarbanes-Oxley Act (SOX), Management & Board of Directors, and Auditors.

Regulatory Agency

The Securities and Exchange Commission’s main responsibilities include ensuring market efficiency and protecting investors from corporations . With the Enron scandal, the SEC’s reputation was undeniably damaged. This is mostly attributable to its failure to detect Enron’s dishonest accounting practices. In order to avoid recurrence, the SEC should be more proactive when it comes to fraud-detection. This means having less reliance on analysts and investors to detect potential instances of fraud, and instead providing a closer monitoring of all registered companies. Essentially, the SEC needs to have an increased oversight on companies and the financial reports they are publishing. Next, more focus should be placed on larger corporations. In particular, corporations who lack clarity in terms of their creative and irregular accounting treatments, and financial statement disclosures. The SEC should also implement constant review of published financial reports of corporations in order to ensure that there is no accounting manipulation. In the case of Enron, the Commission should have followed up after approving mark-to-market, especially since there is a greater risk for earnings management. Overall, changes in the regulatory bodies are essential to prevent future accounting scandals.

Sarbanes-Oxley Act, 2002

Enron along with other infamous accounting scandals of the early 2000s initiated a refinement of accounting regulations. Prior to the Sarbanes-Oxley Act of 2002 (SOX), a weak regulatory environment existed in accounting. This contributed to constant abuse of accounting regulations by professionals, eventually resulting in numerous scandals. Subsequently, SOX was implemented and is enforced by the Securities Exchange Commission to improve the weak regulations and legal environment, as well as to minimize the risk of potential frauds. SOX has many components for compliance with the most relevant to the Enron scandal being: Corporate Responsibility for Financial Reports (Section 302 and 906), Attempts and Conspiracies to Commit Fraud Offenses (Section 902), and Protection for Employees of Publicly Traded Companies Who Provide Evidence of Fraud (Section 806).

Section 302 and 906 allowed for increased accountability and financial literacy of executives. This means that executives can be held liable for material errors in financial statements, especially if it caused investors to lose money. Additionally, they could face up to 20 years of incarceration, fined up to $5 million, or a combination of both. Likewise, those who attempt or conspire to commit fraud could also face the same penalty under Section 902. Lastly, per Section 806, SOX offers whistleblower protection to employees that report fraud. This addition is to ensure that employees will no longer have to fear speaking up about unethical actions as their jobs are legally protected under this Act. With the implementation of SOX, public companies have less incentives to commit fraud due to the stricter regulations and increased punishment. Thus, they have more incentive to remain compliant and ethical.

Management & Board of Directors

Enron’s management played a big role in its demise. In order to prevent the next Enron, it is important to increase board oversight, minimizing financial incentives, and implementing appropriate checks and balances.

Also, management needs to implement better and more representative accounting practices. For instance, mark-to-market was mot the most appropriate accounting method in the energy sector, yet Enron forced its use. It is important for management to choose the method that would accurately represent its financials, not which method would inaccurately boost profits. Additionally, there is also a need for a stronger, more competent audit committee. Conversely, the implementation of SOX ensured independence of the audit committee from management. This allows them to implement a stronger control environment, thus reducing the risk of fraud. Next, it is important that management understands the function of a corporation is not to generously compensate them. It is their responsibility to ensure profitability. If they believe that the company’s bottom line is a direct reflection of their compensation, then there is an increased incentive to inflate earnings. With Enron’s PRC, they are sending a signal emphasizing that employees should only be compensated for contributing to profits, not for their hard work protecting the company. Incentive systems should be in place to reward accomplishments other than financial performance, but also penalize employees for increased accountability. Lastly, it is also important to instill ethical discipline throughout the business organization via proper checks and balances. Management should have oversight over their employees and should be more involved in transactions that a contributing greatly to their bottom line. Similarly, the board of directors should also have oversight over management. All in all, strengthening an Enron-like management is essential to avoid future frauds.

Auditors

Arthur Andersen could have prevented the fraud if they had done their work correctly. However, they had the issue of always wanting to keep clients, in this case Enron, happy and this proved to be their downfall. To prevent recurrence, auditors have to enforce independence more strictly. This will minimize threats such as familiarity and self-interest. Also, it is important to ensure that auditors do not perform consulting services. This prevents self-review threat from occurring. It is important to note that SOX addresses these issues however, auditors must still take the extra step to ensure proper compliance with the regulations.

Conclusion

Overall, Kurt Eichenwald’s Conspiracy of Fools paints a very detailed picture of the events that brought Enron down. Many lessons can be learned from this scandal such as having increased company oversight, auditor independence and more truthful accounting. The Securities and Exchange Commission also played a role in the scandal and consequently instituted a reform to tighten accounting regulations. With the SEC’s effectiveness dependent on analysts, auditors and company personnel, each one of them must contribute in ensuring measures are taken to prevent the next Enron.

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The Prerequisites, Reasons And Consequences For Enron Scandal. (2022, Jun 16). Edubirdie. Retrieved February 5, 2023, from https://edubirdie.com/examples/the-prerequisites-reasons-and-consequences-for-enron-scandal/
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