When Enron Corporation filed for bankruptcy under Chapter 11 protection on December 2, 2001, it was valued at over $60 billion, thus achieving the notoriety of being the largest U.S. corporate failure at that time. The exemplar of American commercial enterprise became a byword for corporate malfeasance.
Enron was brought into being by Chief Executive Officer Kenneth Lay in 1985 from an amalgamation of Houston Natural Gas (HNG), of which he was previously CEO, and InterNorth of Nebraska. The new corporation’s business was centered on some 37,000 miles of natural gas pipelines and supply contracts. Until the late 1980s, gas pipeline operators were required to be buyers and resellers of natural gas as well as transporters of the product. Deregulation motivated Enron to remove the constraints of entering into purchase contracts and reduce their involvement to transportation and tolling. In 1988, a meeting of top executives was told by Lay and his vice chairman Richard Kinder that far from harming their business, deregulation should provide the impetus for reengineering their business.
By 1990, a review of their corporate business strategy led to a reprofiling of the corporation. Some noncore businesses were sold off and the business was relabeled as an energy provider. In reality, this was a move from their previous conservative strategy of developing trading opportunities from a capital asset base to becoming an energy trading entity with capital assets.
This business transformation was led by Jeffrey Skilling, who joined Enron in 1990 from the consultancy business of McKinsey and Co., where he had been senior partner of their energy business. He came with his strategy to turn Enron into an “asset-light” organization, fueling expansion through financial trading. From using their “Gas Bank” to fulfill contractual obligations, their trading from 1992 might be better considered as derivative trading, since Enron was more involved in creating energy and financial markets than selling either products or services.
From its foundation, Enron was saddled with substantial debt inherited from HNG and InterNorth. This was increased in 1988 to buy out some 16 percent of the shareholding held by Irwin Jacobs, a major investor in InterNorth, and later investors, who had threatened to mount a takeover bid for the young Enron. This raised their debt-to-capital ratio to some
75 percent, making the corporation a poor investment risk. Through refinancing, this ratio was reduced, but keeping debt and losses off their consolidated balance sheet eventually led to Enron’s collapse. This was not helped by some of Enron’s less successful ventures, such as Azurix (water/utilities) and Elektro Eletricidade e Servicios (Brazilian electricity utility).
Enron also invested in the internet, buying into RhythmsNetConnections, an independent internet service provider (ISP). While developing a means of hedging following their initial public offering (IPO), Andrew Fastow, who was promoted to chief financial officer (CFO) in 1998, set up the first LJM entity. This was an investment vehicle formed by his family (their initials) that became an integral part of Enron’s SPEs (special purpose entities). Earlier SPEs, such as the Cactus Fund, were legitimately used to create trading liquidity in gas markets. The later SPEs, such as the Raptors and Talon partnerships, became vehicles for “off balance sheet” accounting, avoiding the consolidation of debt, risk, and losses.
Two other Enron ventures also need to be mentioned, since they contributed to a shift in Enron’s reputation with the public and investors. First was the trade in electricity supplies in California. By using their expertise to play the deregulated markets in 1997–98, as the largest power trader, Enron was able to make substantial profits during a crisis period, mostly at the expense of consumers. It was reported that they generated profits of $1.5 billion before suddenly leaving the market.
The other venture was EnronOnline, which was launched in 2000 and where using their strong technical expertise, Enron was able to take advantage of the boom in dotcom technology. The online market created was primarily a tool for their own business rather than as an open or third-party online marketplace. They were able to increase their trading capacity through the immediacy of this internet trading. However, the growth in liquidity of their trading, with the reduction in timescale, now meant that deals were smaller and standardized for simplicity and thus subject to a much decreased profit margin. Whether this influenced the change in trading practice or was a product of practices that were already undergoing change is open to debate.
In February 2001 Jeffrey Skilling became chairman of Enron, a post he held for only six months before resigning on August 14 and returning the responsibility to Ken Lay. The following day, Lay received an anonymous letter that later transpired to have originated from Sherron Watkins, who worked in Enron as an accountant for their SPEs. She expressed her concerns for their insubstantial collateral and their tax implications. Lay met with Watkins and subsequently took legal advice from Enron’s lawyers, Vinson and Elkins.
Enron’s stock value continued to fall, so Lay made efforts to appease the financial community by explaining Enron’s income and disengaging Fastow from their SPEs. However, he and several other Enron executives had been selling their stock since 1999 and continued to do so while aware of the corporation’s serious financial problems.
On October 19, the Wall Street Journal revealed that Fastow had made a profit of over $7 million from his SPE activities. This prompted the Securities and Exchange Commission (SEC) to announce an investigation into these activities. Enron immediately replaced Fastow as CFO and appointed Jeffrey McMahon to replace him. Shortly thereafter, Enron restated its earnings downward by $0.5 billion and increased its debt by $2.6 billion.
Dynergy opened a bid to buy Enron on November 9, supported by Chevron Texaco, though they pulled out of the deal three weeks later following an announcement of a further $700 million loss. Enron’s credit rating crashed to the extent that on December 2 they filed for bankruptcy under Chapter 11 protection. On January 23, 2002, Lay resigned. A report by William Powers following an inquiry by Enron’s Special Investigation Committee blamed Lay, Skilling, and accounting firm Arthur Andersen for the collapse. A subsequent hearing found Arthur Andersen, Enron’s auditors, to be guilty of obstruction of justice for shredding documents while aware of a pending investigation by the SEC.
In May 2006, Lay and Skilling were found guilty of fraud and conspiracy, although Lay died of a heart attack six weeks later and his conviction was quashed. Skilling was sentenced to 24 years in prison and Fastow to seven years, with lesser sentences handed out to others. Enron stockholders are still working to minimize their losses.
- Stephen Arbogast, Resisting Corporate Corruption: Lessons in Practical Ethics from the Enron Wreckage (Scrivener, 2008);
- Robert L. Bradley, Corporate Social Responsibility and Energy: Lessons From Enron (Institute for Study of Economics and the Environment, Lindenwood University, 2008);
- Kurt Eichenwald, Conspiracy of Fools: A True Story: Collapse of the Enron Corporation: Hearing Before the Committee on Commerce, Science, and Transportation (U.S. G.P.O., 2005);
- Gladwell, “Open Secrets: Enron and the Perils of Full Disclosure,” New Yorker (January 8, 2007);
- Helman and D. Fisher, “Crime Pays the Enron Trial Will Have One Happy Result: For the Market Value of the Prosecutors,” Forbes (v.177/13, June 19, 2006);
- John Kroger, Convictions: A Prosecutor’s Battles Against Mafia Killers, Drug Kingpins, and Enron Thieves (Farrar, Straus, and Giroux, 2008);
- Bethany McLean and Peter Elkind, “Enron Diary,” Fortune (v.153/4, 2006);
- Powers, Jr., Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp. (February 1, 2002);
- Malcolm S. Salter, Innovation Corrupted: The Origins and Legacy of Enron’s Collapse (Harvard University Press, 2008).
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