Enron
From Invertopedia, the encyclopedia of how things fail
Enron turned a Houston gas pipeline company into the seventh largest company in the United States, trading energy contracts like securities[2]. It used accounting that booked the expected profit on a long contract the day it was signed[6], and partnerships run by its own finance chief to keep debt and losses off its books[2][7]. When those deals came to light in October 2001 the stock collapsed, and Enron filed for bankruptcy on December 2, 2001[2]. Losses were estimated at $74 billion[1].
Contents
The bet
Enron believed it was a trading and technology company, not a pipeline company. It built an online business that traded contracts for gas, oil and electricity, and moved into new markets such as broadband[2]. Fortune named it America's most innovative company six years in a row[8].
That business needed a high credit rating, and its earnings swung from quarter to quarter[2]. So the company set out to show steady earnings growth, low debt and strong cash flow on its financial statements, whatever the underlying business was doing[2][3].
What happened
| 1985 | Houston Natural Gas merges with InterNorth to form Enron. Kenneth Lay becomes chairman and CEO the next year.[1] |
|---|---|
| 1992 | The SEC approves Enron's use of mark-to-market accounting, which lets it book a contract's estimated future value up front.[6] |
| 1996 – 2001 | Fortune names Enron "America's Most Innovative Company" six years running.[8] |
| Jan 2001 | The stock passes $80 a share, up from about $30 in early 1998.[3] |
| Mar 2001 | A Fortune article, "Is Enron Overpriced?", questions its opaque financial statements.[2] |
| Aug 2001 | CEO Jeffrey Skilling resigns. The next day Sherron Watkins writes to Lay that his exit "will raise suspicions of accounting improprieties."[2] |
| Oct 2001 | Enron discloses a $1.2 billion cut in shareholder equity tied to the Raptors, and has to bring Chewco onto its books with a $500 million loss.[2] |
| Nov 2001 | A rescue merger with Dynegy fails and the credit agencies cut Enron below investment grade.[2] |
| Dec 2, 2001 | Enron files for Chapter 11, then the largest bankruptcy in U.S. history.[1][2] |
| May 25, 2006 | A Houston jury convicts Skilling and Lay of fraud and conspiracy. Lay dies in July, before he is sentenced, and in October a judge vacates his conviction.[1][3][9] |
The kill shot
The profits were booked before they were earned, and the debt was moved to places nobody was looking. Once the market saw the hidden part, there was nothing left to hold the stock up.
Mark-to-market accounting let Enron record the estimated value of a long contract as soon as it was signed, so a ten-year deal could show up as profit on day one[6]. When those estimates fell short, the losses had to go somewhere. The SEC charged that Skilling and others kept over $1 billion of earnings in undisclosed reserves and released them to report results the business had not produced[10].
The rest went off the books. The SEC charged that finance chief Andrew Fastow secretly controlled partnerships such as Chewco and LJM, and that in one deal an LJM partnership bought an asset from Enron under an unwritten promise that Enron would buy it back at a guaranteed profit[7]. Senate investigators found the Board knowingly let Enron move at least $27 billion, almost half its assets, off the balance sheet[2].
Red flags ignored
- Profit with no cash. Mark-to-market earnings came from estimates, not from money received.[6]
- The CFO on both sides. Fastow ran the partnerships that traded with Enron.[7]
- Half the company off the books. Experts told the Senate they knew of no other public company with so much off the balance sheet.[2]
- Statements nobody could read. In March 2001 Fortune asked why the numbers were so opaque.[2]
- A CEO who walked out. Skilling quit in August 2001, months before the collapse, and the Board did not treat it as a warning.[2]
The cost
Estimated losses of $74 billion[1]. The stock, over $80 a share in January 2001[3], was below $1 by late November 2001[6]. Enron had $63.4 billion in assets when it filed[6].
Thousands of employees lost their jobs and a large part of their retirement savings, and creditors around the world were left expecting pennies on the dollar[2].
The inversion
If you can't explain where the profit comes from in one sentence, it may not be there. Count the cash, and treat every entity that holds your debt as part of the company.
What survived
The prosecutions. Fastow pleaded guilty and agreed to give up more than $23 million in the SEC case[4]. Skilling was convicted on 19 counts, sentenced to 292 months, and resentenced in 2013 to 168 months, forfeiting about $42 million for victims[3]. He was released in February 2019[1].
Enron's auditor, Arthur Andersen, was indicted for obstruction of justice after its staff destroyed Enron documents, and convicted[1]. The Supreme Court unanimously overturned that conviction in 2005 because the jury instructions were wrong[5].
References
- ^ “Enron Fast Facts”. CNN Newsource via KVIA, April 25, 2021. The 1985 merger, Skilling's 1990 hire, the $74 billion estimate of losses, the bankruptcy date, Andersen's document destruction and indictment, the May 2006 verdicts, Lay's death, Skilling's 2019 release.
- ^ “The Role of the Board of Directors in Enron's Collapse (S. Prt. 107-70)”. U.S. Senate Permanent Subcommittee on Investigations, July 8, 2002. Enron as the seventh largest U.S. company with over $100 billion in revenue and 20,000 staff, the December 2, 2001 bankruptcy, at least $27 billion or almost 50 percent of assets off the balance sheet with Board approval, the March 2001 Fortune article, the Watkins letter, the October 2001 $1.2 billion equity reduction and Chewco loss, the failed Dynegy merger, and employees' lost savings.
- ^ “Former Enron CEO Jeffrey Skilling Resentenced to 168 Months for Fraud, Conspiracy Charges”. U.S. Department of Justice, June 21, 2013. Skilling's May 25, 2006 conviction counts, the 292-month 2006 sentence, the 2009 appeal, the 168-month resentence, the $42 million forfeiture, and the stock's rise from about $30 to over $80 a share.
- ^ “SEC Settles Civil Fraud Charges Filed Against Andrew S. Fastow (Litigation Release 18543)”. U.S. Securities and Exchange Commission, January 14, 2004. Fastow's guilty plea in the criminal case and more than $23 million in disgorgement.
- ^ “Arthur Andersen LLP v. United States, 544 U.S. 696”. U.S. Supreme Court, May 31, 2005 (Legal Information Institute). The unanimous reversal of Andersen's obstruction conviction over the jury instructions.
- ^ “The Enron Scandal (2001)”. International Banker. Mark-to-market accounting approved by the SEC in 1992 and how it booked future profits on signing, the Blockbuster deal, the Raptors, the stock below $1 by late November 2001, the $63.4 billion of assets, about 4,000 jobs and the employees' savings plans.
- ^ “SEC Charges Fastow, Former Enron CFO, With Fraud (Press Release 2002-143)”. U.S. Securities and Exchange Commission, October 2, 2002. Fastow's control of LJM1, LJM2 and Chewco, Chewco kept off the books, the Cuiaba and Nigerian barge sales with secret buybacks.
- ^ “Enron Named Most Innovative for Sixth Year (Enron press release, February 6, 2001)”. Enron Corp. press release, reproduced by Propaganda Critic. Fortune's "Most Innovative Company in America" for the sixth consecutive year and $101 billion of 2000 revenue, in Enron's own words.
- ^ “Judge throws out convictions of Enron's Lay”. Associated Press via NBC News, October 17, 2006. Judge Sim Lake vacating Lay's conviction after his death.
- ^ “SEC Charges Jeffrey K. Skilling, Enron's Former President, CEO and COO, With Fraud (Litigation Release 18582)”. U.S. Securities and Exchange Commission, February 19, 2004. Over $1 billion of hidden reserves used to manage earnings, losses moved between divisions, the LJM and Raptor deals, and about $63 million of stock sales.