ENRON SCANDAL – A STUDY

UNDER SUPERVISION OF

FACULTY:

Prof. Shashank Kumar

NAME:

1.RAMYA.S.R.

REG. NO: 180401420044

2. PRIYADHARSHINI.P

REG. NO: 180401420039

COURSE: BBA.LLB- SEMESTER VI

SUBJECT: CAPITAL MARKETS AND REGULATIONS

ALLIANCE SCHOOL OF LAW

3rd May 2021

Content
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Introduction…………………………………………………..…3

Research question……………………………………………….3

Hypothesis………………………………………………………3

case background…………………………………………………4

what went wrong…………………………………………………6

 Accounting and audit failure - Violation of GAAP Provisions..7

 Negligent behaviours of BOD……………………………….8

Aftermath of Enron scandal……………………………………..9

Conclusion………………………………………………………11

Introduction

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Accounting scandals are business scandals which arise because of intentionally manipulating
the financial statements with the disclosure of financial misdeeds by trusted executives of
corporations or governments. These misdoings may include complex methods for misusing or
misdirecting funds, overstating revenues, understating expenses, overstating the value of
corporate assets, or underreporting the existence of liabilities (this can be done either
manually, or by the means of deep learning). It involves an employee, account, or corporation
itself and is misleading to investors and shareholders. This type of "creative accounting" can
amount to fraud, and investigations are typically launched by government oversight agencies,
such as the Securities and Exchange Commission (SEC) in the United States and Securities
exchange board of India (SEBI) in India. Employees who commit accounting fraud at the
request of their employers are subject to personal criminal prosecution. Some of the very
important scandals of such nature during early 2000’s are Waste Management Scandal
(1998), Enron Scandal (2001), WorldCom Scandal (2002), Tyco Scandal (2002),
HealthSouth Scandal (2003), Freddie Mac Scandal (2003), American International Group
(AIG) Scandal (2005), Lehman Brothers Scandal (2008), Satyam Scandal (2009)1. Enron
scandal was one of those important scandals in the history of accounting. This is an
accounting scandal committed by the Enron corporation, an American energy company.

Research Problem

After the Enron scandal the Sarbanes-Oxley Act was formulated in order to prevent these
types of scandals from happening and to make changes to the rules relating to securities and
to access the financial statements of all the companies and to protect the interest of the
investors and employees. So, did it fulfil its purpose?

Hypothesis

Yes, the Sarbanes- Oxley act fulfilled its purpose of protecting the interest of investors and
the employees by making the financial statements more accessible.

Case Background

1
< https://corporatefinanceinstitute.com/resources/knowledge/other/top-accounting-scandals/ > accessed on 28th
April 2021

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Enron scandal was one of the biggest scandal in the history of America.  The company came
into existence in the year of 1985 as a result of merger between Houston natural Gas and
Internorth, at the time of merger both the companies being relatively small regional
companies. In beginning stages, the company was simply a natural gas provider. By the year
1989, Enron began trading in natural gas commodities, and by 1994, it started trading in
electricity as well. That was really a very fast transformation and enlargement of the
company. Enron provided employment opportunities to approximately 20,000 people. It was
one of the world’s leading electricity, natural gas, paper and communication companies. The
company claimed approximate revenue of nearly $101 billion in the year 2000. The company
exclusively dealt in the trade of sugar, coffee, grains, hog and other meat products. It made
revolutionary changes in the energy trading which allowed it to grow this fast. Enron
strategically made the electricity and natural gas contracts which helped in effectively
minimizing 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.
Enron's auditor Arthur Andersen, whose Enron audit and consulting fees were around $ 52
million a year. Enron also employed several former Andersen partners as senior financial
executives. In February 2001, Andersen's partners discussed the possibility of abandoning
their client due to Enron's accounting policies, including accounting for SPEs and the
apparent conflicts of interest of Enron's chief financial officer, Andrew Fastow, who had
established himself and it was benefiting from SPEs. In August 2001, Skilling resigned and
Kenneth Lay, the president, assumed executive control(CEO). Lay was a close friend of the
President of the United States, George W. Bush, and was his advisor on energy matters. His
name had been mentioned as the future Secretary of Energy of the United States. In 2000,
Lay earned £ 123 million from exercising stock options in Enron. A week after Skilling
resigned, Chung Wu, a broker for UBS Paine Webber US (a subsidiary of Swiss bank UBS),
sent an email to his clients warning them to sell Enron. He was fired and escorted out of his
office. On the same day, Lay sold his own $ 4 million worth of Enron shares, while telling
employees the high priority he placed on restoring investor confidence, which "should result
in a price of the shares. shares. Shares on the rise ". Other UBS analysts continued to
recommend a "strong buy" at Enron. UBS Paine Webber received significant brokerage fees
for managing Enron's employee stock option program. Lord Wakeham, a former UK cabinet
minister, was a director of Enron and chair of its nominating committee. Wakeham, who was

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also a Chartered Accountant and Chairman of the British Press Complaints Council, received
an annual consulting fee of $ 50,000 from Enron, plus a monthly advance of $ 4,600 and an
attendance fee of $ 1,250 for each meeting. In mid-2001, Sherron Watkins, an Enron
executive, warned Lay about the company's accounting techniques. In October 2001, a crisis
developed, when the company reviewed its previous financial statements and revealed
massive losses attributable to the hedging risks assumed by the fall in energy prices, which
had ended with $ 600 million in profits. An SEC investigated this earnings restatement over
the past five years revealed massive and complex derivative transactions and positions
between Enron and SPEs. Debts were underestimated by $ 2.6 billion. It is alleged that
Fastow received more than $ 30 million for his management of the associations. Ultimately,
he was indicted on 78 counts related to complex financial schemes that produced phantom
profits, enriched him, and convicted the company. He claimed that he did not believe he had
committed any crime. The FBI launched an investigation into a possible fraud at Enron three
months later, at which point the files had been destroyed. In a subsequent criminal trial,
Andersen was found guilty of destroying key documents, as part of an effort to avoid an
official investigation into the collapse of the power company. Lawsuits against Andersen
followed. Enron's employee pension fund sued for $ 1 billion, plus fee refunds of $ 1 million
per week, calling the company its best chance to recoup some of the lost $ 80 billion. in the
Enron debacle. Many Enron employees had their retirement plans in Enron shares; some had
lost all of their retirement savings. The US Department of Labor alleged that Enron had
illegally prohibited employees from selling company stock in its "401k" retirement plans as
the share price fell. The Andersen firm subsequently collapsed, with partners from around the
world joining other "Big Four" firms. In November 2001, Fastow was fired. Standard and
Poor's, the credit rating agency, downgraded Enron's shares to junk bonds, resulting in
penalties on interest rates and other clauses. Merger negotiations with Dynergy, which could
have saved Enron, failed. Enron filed for Chapter 11 bankruptcy in December 2001. This was
the largest corporate collapse in US history until then - Worldcom was going to get over it.
The NYSE suspended Enron's shares. John Clifford Baxter, a vice- chair of Enron until his
resignation in May 2001, was found shot dead. He had been one of the first to see the
problems at Enron and had heated arguments about the accounting for off-balance-sheet
financing, which he found unacceptable. Two outside directors, Herbert Weinokur and
Robert Jaedicke, members of the Enron audit committee, claimed that the board either was
not informed or was deceived about deals involving the SPEs. Early in 2002, Duncan, the
former lead partner on Enron’s audit, who had allegedly shredded Enron files and been fired

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by Andersen, cooperated with the Justice Department’s criminal indictment, becoming a
whistle blower and pleading guilty to charges that he had ‘knowingly, intentionally and
corruptly persuaded and attempted to persuade Andersen partners and employees to shred
documents’. In January 2002, The US Department of Justice started a criminal proceeding
against Enron’s collapse. On January 10th 2002, Arthur Anderson LLP, the accounting firm
that handled Enron’s audits, disclosed that the company has destroyed all the relevant
documents. On January 15th 2002, The New York Stock Exchange suspends trading of Enron
shares on its stock exchange. On January 17th 2002, the partnership between Enron and
Arthur ended. In March 2002, Arthur was declared guilty of obstruction of justice and its
licence to audit pubic companies was revoked. In 2006, the company officials Skilling and
Lay were convicted of fraud and conspiracy.  Additional charges of insider trading and
making false statement were proved. Lay died of heart attack while awaiting sentence. In
2008, A class action lawsuit was filed by shareholders and investors of Enron and the
settlement was arrived at in the federal court.  An amount of $7.2 billion was paid out by a
group of banks accused of participating in the fraud. In 2013, Skilling’s sentence was reduced
as he forfeited $42 million to be distributed among the victims of Enron fraud. In 2015, the
SEC announced its judgement against Skilling barring him from serving as an officer or
Director of any public company. On 21st February 2019, Skilling was finally released after
serving over 12 years in the federal prison.2

The issue or the scandal was first noticed when the balance sheets of Enron were analysed. It
was found that enron was 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.

WHAT WENT WRONG?

Enron was considered to be at the time one of the innovative company in the market and was
accorded with several praises in America and also all over the world. But the truth was that
the Company had been nothing but lying to the world and also its trusted shareholders and
were in debts from which they could never fully recover. In the beginning of 2001, the shares

2
Peter Bondarenko, “Enron scandal” < https://www.britannica.com/event/Enron-scandal > accessed on 29th
April 2021

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of Enron were worth around a whooping 90 dollars in the market, but the next year, the
shares were not worth than a dollar in the market, which was such a shock for the
shareholders of the company.

The question that arises now is how could the company be able to mask such a grave
situation completely different to the world, and most importantly were there more than one
reason for the collapse of Enron. To answer that, from the analysis conducted for this paper,
there two to three major reasons and issues due which the company had the downfall. Those
are as follows:

1. Accounting and Audit Failure- Violation of GAAP Provisions:

At the time the scandal took place, the US Congress had implemented the Foreign Corrupt
Practices Act in the year, 1977 to avoid all kinds of Financial Irregularities in the Financial
market like violation of Accounting System, corporate bribery and many more like fraud, etc.

But even with such Acts, the Enron Corporation violated few major provisions of the
Generally Accepted Accounting Principles through their activities. They are:
o Mark to Market Method: The mark to market method was an established
accounting method, which the US Securities and Exchange Commission allowed
the Enron Corporation in good faith, but the Company had adopted this method to
hide their losses and this helped them to hide their financial position from the
investors, regulators and analysts. This method determines the fair value of
accounts that fluctuate over time, including assets and liabilities. Based on current
market conditions, mark to market method tends to provide a practical assessment
of a company's current financial position. The market value of an asset is
measured by the amount a business would receive if it were sold at that time. A
company's balance sheet must represent the current market value of some
accounts at the end of the fiscal year, while other accounts will retain their
historical cost, which is the asset's original purchasing price.
Enron Corporation's CEO and CFO exploited this method by inflating stock
prices and covering massive losses while continuing to gain major capital
investment, which was both illegal and unethical, and misled the SEC into
approving the use of this accounting method.

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 o Off Balance sheet Financing: Off-Balance Sheet  Financing is a type
of accounting process in which businesses report certain assets or liabilities in
such a way that they do not appear on the balance sheet. It's used to hold debt-to-
equity and leverage ratios low, particularly if a large outlay will violate negative
debt covenants. Enron used Special Purpose Vehicles which are also known as
special purpose entity, a form of off-balance sheet financing method, to hide its
massive debts from investors, auditors, and regulators. The SPVs consisted of a
number of shell accounts. The aim of these SPVs was to increase financial
stability, lower the cost of borrowing from creditors, lower the tax burden, and
maximise profits.

o The audit reports and auditors of Enron produced financial statements that were
irregular and later found to be contradicting the provisions of GAAP, causing
unethical practices.

o The accounting firm’s founder for Enron, was the one facilitating these ideas to
bury the debts of the company and also was involved in destroying financial
statements and documents that were being processed for investigation.

 Security Analysts of the investment banks of Enron Corporation, even after the
company had collapsed and its market price being severely affected, still made
recommendation for investors to buy shares in Enron.

2. Negligent Behaviour of the Board of Directors and Inadequate

Corporate Governance:
 The board members of a corporate company are independent and function without any
pressure from the company. But the board of directors of Enron did not perform their
responsibilities and duties to the best of their abilities.
 Firstly, the BOD were not independent and the composition of the board members
were also not correct along with the roles of the non- executive directors not being
accurate. There were several reports stating that the Board members were given
incentives in order for them to turn a blind eye towards the company’s irregularities.

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  The BOD were responsible in observing the corporate governance of the company,
but they failed to foster a successful governance. The reason for this failure is that, the
BOD did not control the CEO and CFO’s excessive use of their powers, they also did
not act towards the interests of the shareholders by not reporting the company’s
fraudulent activities.
 The BOD did not have proper allocated risk management capital, when they realized
the Company had been undertaking high risk businesses, even after knowing that their
capital market was not sufficient for such new undertakings.
 The most important negligent act committed by the BODs is towards not appointing
proper external auditor to keep a check on the internal auditing department and also
their role in not properly disclosing the position of the Company with the
Shareholders.
 Company’s are required to provide retirement schemes for their employees, and
Enron too had a scheme called the 401’K’ retirement plan, where shares were issued
to the employees. Almost 60% of the shares in it were held by the employees. But
when the Company collapsed, the share price reduced very low and due to which the
employees faced huge losses. This raised a lot of questions relating to protection of
employees rights.

AFTERMATH OF THE ENRON SCANDAL:

After the Enron scandal, the US SEC felt that the current provisions were being misused by
several corporate entities like Enron. After the Enron Scandal, several issues were brought
upon and investors and shareholders were looking for solutions for such issue and also for
protection of shareholder interests.. Few of those issues were- roles and duties of auditors
audit reporting, pension scheme issues, security analysts, and also the extent of corporate
disclosure.

So in 2002, as result of several company having similar accounting problems, the 107 th US
Congress passed the Sarbanes- Oxley Act. This act was introduced with the main intention to
make changes to the rules relating to securities and to access the financial statements of all
the companies. The act was passed in a way with provisions relating to the issues raised after
the Enron Scandal, for example, as relating to the pension schemes, the act now makes it

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mandatory for the companies to allow the participants to receive more information, and many
other benefits for the employees.3

Few of the major provisions enforced by this act are as follows:

- Publicly traded firms must gain audit independence, where, the board of auditors must
certify that the financial statements are accurate and the audit committee will be
separate from management  
- As they thoroughly analyse financial statements, financial analysts have a degree of
independence. Also states about the financial analyst's current involvement with
investment banks, including the declaration of any potential conflicts of interest in the
stocks recommended.
- All publicly traded companies can release all financial information that relates to the
company's financial performance  in the market.
- Act also deals with the SEC's technical budgetary aspects.
- When a company's directors is obstructing an investigation, the SEC has the power to
suspend them from their current positions if the directors are guilty of fraud.
- Other provisions to improve the transparency of disclosure of financial statements.
- Increase the criminal penalty for a variety of securities fraud offences, such as
deceiving an auditor, mail and wire fraud, and record destruction.
- This act also gave directions on how to tackle illegal insiders trading.

These are few of the provisions from the Sarbanes- Oxley Act,2002.

After the Scandal, there were also changes made in the Financial Accounting Standard Board
relating to ethical conduct, which stated the requirement for the Board of Directors to be
Independent for proper functioning of the company. These are the ones that made the board
question the ethical conduct of Enron,

• Removing Debts from Balance Sheet

• Showing Increased Profits

• Covering up of financial issues

• Acquiring funding (Enron & Investment Banks)

3
Prof. Edel Lemus “The Financial Collapse of the Enron Corporation and Its Impact in the United States Capital
Market” , Global Journals Inc. (USA), Volume 14 Issue 4 Version 1

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 • Lack of Whistle Blowing

• Executive and Spouses selling stock prior to downfall

• Shareholders and Employees receiving small settlement

Conclusion

The unprecedented financial occurrence in the Enron Corporation showed that major
corporate organizations in the gas and utility industry were manipulating the company’s
financial statements for their own personal gain. Enron has also brought another main issue
of America’s capital markets that is, employees are putting much if not all their savings into
buying their company’s shares in the form of retirement schemes, whereas, executives unload
the stocks they receive, with an insider’s knowledge of when it is best to sell the stocks. This
made the state to bring more standard form of regulation. Now coming to the research
problem, yes, Sarbanes-Oxley act did fulfil its part. The implementation of the Sarbanes-
Oxley Act of 2002 helped align and reshape publicly traded companies financial reporting
system. The U.S. Securities and Exchange Commission (SEC) required publicly traded
companies with a flow capital of $75 million to comply with the Sarbanes-Oxley Act of 2002
and the SOX cost of compliance internal control system is $3.5 million as a result since the
adoption of the Sarbanes-Oxley Act of 2002, auditors and publicly traded companies have
been experiencing a high cost of compliance in the financial market among economies of
scale. It also helped in preventing the employees being exploited, which can be seen in the
provision regarding the pensions. Though this act was effective at the time of its formulation,
the time is changing, the misdeeds too. People who commit the crime are keep on evolving,
to beat these issues, the law also has to keep up with it and has to keep on evolving.

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