The Enron Collapse: An Overview of Financial Issues
Released: 2004-08-12T00:00:00

RS21135 -- The Enron Collapse: An Overview of Financial Issues

Updated August 12, 2004

Enron: What Went Wrong?

Enron Corp., the first nationwide natural gas pipeline network, shifted its business focus during the 1990s from the regulated transportation of natural gas totrading in unregulated energy markets. Until late 2001, nearly all observers -- including Wall Street professionals-- regarded this transformation as anoutstanding success. Enron's reported annual revenues grew from under $10 billion in the early 1990s to $139billion in 2001, placing it fifth on the Fortune500. Enron continued to transform its business but, as it diversified out of its core energy operations, it ran intoserious trouble. Like many other firms, Enronsaw an unlimited future in the Internet. During the late 1990s, it invested heavily in online marketers and serviceproviders, constructed a fiber opticcommunications network, and attempted to create a market for trading broadband communications capacity. Enronentered these markets near the peak of theboom and paid high prices, taking on a heavy debt load to finance its purchases. When the dot com crash came in2000, revenue from these investments driedup, but the debt remained.

Enron also recorded significant losses in certain foreign operations. The firm made major investments in public utilities in India, South America, and the U.K.,hoping to profit in newly-deregulated markets. In these three cases, local politicians acted to shield consumers fromthe sharp price increases that Enronanticipated.

By contrast, Enron's energy trading businesses appear to have made money, although that trading was probably less extensive and profitable than the companyclaimed in its financial reports. Energy trading, however, did not generate sufficient cash to allow Enron towithstand major losses in its dot com and foreignportfolios. Once the Internet bubble burst, Enron's prospects were dire.

It is not unusual for businesses to fail after making bad or ill-timed investments. What turned the Enron case into a major financial scandal was the company'sresponse to its problems. Rather than disclose its true condition to public investors, as the law requires, Enronfalsified its accounts. It assigned business lossesand near-worthless assets to unconsolidated partnerships and "special purpose entities." In other words, the firm'spublic accounting statements pretended thatlosses were occurring not to Enron, but to the so-called Raptor entities, which were ostensibly independent firmsthat had agreed to absorb Enron's losses, butwere in fact accounting contrivances created and entirely controlled by Enron's management. In addition, Enronappears to have disguised bank loans as energyderivatives trades to conceal the extent of its indebtedness.

When these accounting fictions -- which were sustained for nearly 18 months -- came to light, and corrected accounting statements were issued, over 80% ofthe profits reported since 2000 vanished and Enron quickly collapsed. The sudden collapse of such a largecorporation, and the accompanying losses of jobs,investor wealth, and market confidence, suggested that there were serious flaws in the U.S. system of securitiesregulation, which is based on the full andaccurate disclosure of all financial information that market participants need to make informed investment decisions. The suggestion was amply confirmed bythe succession of major corporate accounting scandals that followed.

Enron raised fundamental issues about corporate fraud, accounting transparency, and investor protection. Several aspects of these issues are briefly sketchedbelow, with reference to CRS products that provide more detail.

Auditing and Accounting Issues

Federal securities law requires that the accounting statements of publicly traded corporations be certified by an independent auditor. Enron's auditor, ArthurAndersen, not only turned a blind eye to improper accounting practices, but was actively involved in devisingcomplex financial structures and transactions thatfacilitated deception.

An auditor's certification indicates that the financial statements under review have been prepared in accordance with generally-accepted accounting principles(GAAP). In Enron's case, the question is not only whether GAAP were violated, but whether current accountingstandards permit corporations to play"numbers games," and whether investors are exposed to excessive risk by financial statements that lack clarity andconsistency. Accounting standards forcorporations are set by the Financial Accounting Standards Board (FASB), a non-governmental entity, though thereare also Securities and ExchangeCommission (SEC) requirements. (The SEC has statutory authority to set accounting standards for firms that sellsecurities to the public.) Some describeFASB's standards setting process as cumbersome and too susceptible to business and/or political pressures.

In response to the auditing and accounting problems at Enron and other major corporations scandals, Congress enacted the Sarbanes-Oxley Act of 2002 ( P.L.107-204 ), containing perhaps the most far-reaching amendments to the securities laws since the 1930s. Very briefly,the law does the following:

creates a Public Company Accounting Oversight Board to regulate independent auditors of publicly traded companies -- a private sectorentity operating under the oversight of the SEC;

raises standards of auditor independence by prohibiting auditors from providing certain consulting services to their audit clients andrequiring preapproval by the client's board of directors for other nonaudit services;

requires top corporate management and audit committees to assume more direct responsibility for the accuracy of financialstatements;

enhances disclosure requirements for certain transactions, such as stock sales by corporate insiders, transactions with unconsolidatedsubsidiaries, and other significant events that may require "real-time" disclosure;

directs the SEC to adopt rules to prevent conflicts of interest that affect the objectivity of stock analysts;

authorizes $776 million for the SEC in FY2003 (versus $469 million in the Administration's budget request) and requires the SEC toreview corporate financial reports more frequently; and

establishes and/or increases criminal penalties for a variety of offenses related to securities fraud, including misleading an auditor, mailand wire fraud, and destruction of records.

See also CRS Report RL31554 , Corporate Accountability: Sarbanes-Oxley Act of 2002: ( P.L. 107-204 ) , by Michael Seitzinger; and CRS Report RS21120 , Auditing and its Regulators: Proposals for Reform After Enron, by [author name scrubbed].

Pension Issues

Like many companies, Enron sponsored a retirement plan -- a "401(k)" -- for its employees to which they can contribute a portion of their pay on atax-deferred basis. As of December 31, 2000, 62% of the assets held in the corporation's 401(k) retirement planconsisted of Enron stock. Many individualEnron employees held even larger percentages of Enron stock in their 401(k) accounts. Shares of Enron, which inJanuary 2001 traded for more than $80/share,were worth less than 70 cents in January 2002. The catastrophic losses suffered by participants in the EnronCorporation's 401(k) plan have promptedquestions about the laws and regulations that govern these plans.

In the 107th Congress, the House passed legislation ( H.R. 3762 ) that would have required account information to be provided moreoften to plan participants, improved access to investment planning advice, allowed plan participants to diversifytheir portfolios by selling company stockcontributed by employers after three years, and barred executives from selling company stock while a plan is "lockeddown." (The latter provision was enactedby the Sarbanes-Oxley Act.) Similar legislation has not advanced in the 108th Congress.

See also CRS Report RL31507 , Employer Stock in Retirement Plans: Investment Risk and Retirement Security , by [author name scrubbed] ([phone number scrubbed]); and CRS Report RL31551 , Employer Stock in Pension Plans: Economic and Tax Issues, by Jane Gravelle.

Corporate Governance Issues

In the wake of Enron and other scandals, corporate boards of directors were subject to critical scrutiny. Boards, whose chief duty is to represent shareholders'interests, utterly failed to prevent or detect management fraud. Several provisions of Sarbanes-Oxley were designedto boost the power of independent directorsand the audit committee of the board to exercise effective oversight of management and the accounting process.Under Sarbanes-Oxley, the board's auditcommittee must have a majority of independent directors (not affiliated with management or the corporation) andis responsible for hiring, firing, overseeing,and paying the firm's outside auditor. The audit committee must include at least one director who is a financialexpert, that is, able to evaluate significantaccounting issues and/or disagreements between management and auditors.

In 2003, the New York Stock Exchange and the Nasdaq adopted rules requiring listed corporations to have a majority of independent directors (not affiliatedwith management or the corporation) on their boards. In 2004, the SEC is considering a rule that would facilitatethe nomination of directors by shareholders.

Securities Analyst Issues

Securities analysts employed by investment banks provide research and make "buy," "sell," or "hold" recommendations. These recommendations are widelycirculated and are relied upon by many public investors. Analyst support was crucial to Enron because it requiredconstant infusions of funds from the financialmarkets. On November 29, 2001, after Enron's stock had fallen 99% from its high, and after rating agencies haddowngraded its debt to "junk bond"status,only two of 11 major firm analysts rated its stock a "sell." Was analyst objectivity -- towards Enron and other firms-- compromised by pressure to avoidalienating investment banking clients?

The Sarbanes-Oxley Act directs the SEC to establish rules addressing analysts' conflicts of interest; these were issued in 2003. In December 2002, 10 majorinvestment banks reached a settlement with state and federal securities regulators under which they agreed toreforms to make their analysts independent of theirbanking operations, and to pay fines totaling about $1 billion.

See also CRS Report RL31348(pdf) , Enron and Stock Analyst Objectivity , by [author name scrubbed].

Banking Issues

One part of the fallout from Enron's demise involves its relations with banks. Prominent banking companies, notably Citigroup and J.P. Morgan Chase, wereinvolved in both the investment banking (securities) and the commercial banking (lending and deposit) businesseswith Enron. In 2003, the SEC fined the twobanks $120 and $135 million, respectively, for their roles in Enron's accounting frauds.

Several aspects of Enron's relations with its bankers have raised several questions. (1) Do financial holding companies (firms that encompass both investmentand commercial banking operations) face a conflict of interest, between their duty to avoid excessive risk on loansfrom their bank sides versus their opportunityto glean profits from deals on their investment banking side? (2) Were the bankers enticed or pressured to providefunding for Enron and recommend itssecurities and derivatives to other parties? (3) Did the Dynegy rescue plan, proposed just before Enron's collapse,and involving further investments by J.P.Morgan Chase and Citigroup, represent protective self-dealing? (4) What is the proper accounting for banks'off-balance-sheet items including derivativepositions and lines of credit, such as they provided to Enron? (5) Did the Enron situation represent a warning thatGLBA may need fine-tuning in the way itmixes the different business practices of Wall Street and commercial banking?

See also CRS Report RS21188, Enron's Banking Relationships and Congressional Repeal of Statutes Separating Bank Lending from Investment Banking , by[author name scrubbed].

Energy Derivatives Issues

Part of Enron's core energy business involved dealing in derivative contracts based on the prices of oil, gas, electricity and other variables. For example, Enronsold long-term contracts to buy or sell energy at fixed prices. These contracts allow the buyers to avoid, or hedge,the risks that increases (or drops) in energyprices posed to their businesses. Since the markets in which Enron traded are largely unregulated, with no reportingrequirements, little information is availableabout the extent or profitability of Enron's derivatives activities, beyond what is contained in the company's ownfinancial statements. While trading inderivatives is an extremely high-risk activity, no evidence has yet emerged that indicates that speculative losses werea factor in Enron's collapse.

Since the Enron failure, several energy derivatives dealers have admitted to making "wash trades," which lack economic substance but give the appearance ofgreater market volume than actually exists, and facilitate deceptive accounting (if the fictitious trades are reportedas real revenue). In 2002, energy derivativestrading diminished to a fraction of pre-Enron levels, as major traders (and their customers and shareholders)re-evaluate the risks and utility of unregulatedenergy trading. Several major dealers have withdrawn from the market entirely.

Internal Enron memoranda released in May 2002 suggest that Enron (and other market participants) engaged in a variety of manipulative trading practicesduring the California electricity crisis. For example, Enron was able to buy electricity at a fixed price in Californiaand sell it elsewhere at the higher marketprice, exacerbating electricity shortages within California. The evidence to date does not indicate that energyderivatives - as opposed to physical, spot-markettrades -- played a major role in these manipulative strategies. Numerous firms and individuals have been chargedwith civil and criminal violations related tothe manipulation of energy prices in California and elsewhere.

Even if derivatives trading was not a major cause, Enron's failure raises the issue of supervision of unregulated derivatives markets. Would it be useful ifregulators had more information about the portfolios and risk exposures of major dealers in derivatives? AlthoughEnron's bankruptcy appears to have hadlittle impact on energy supplies and prices, a similar dealer failure in the future might damage the dealer's tradingpartners and its lenders, and couldconceivably set off widespread disruptions in financial and/or real commodity markets.

Legislation proposed, but not enacted, in the 107th Congress ( H.R. 3914 , H.R. 4038 , S. 1951 , and S. 2724 )would have (among other things) given the CFTC more authority to pursue fraud (including wash transactions) inthe OTC market, and to require disclosure ofcertain trade data by dealers. In the 108th Congress, the Senate twice rejected legislation ( S.Amdt. 876 and S.Amdt. 2083 ) that wouldhave increased regulatory oversight of energy derivatives markets by the CFTC and FERC.

See also CRS Report RS21401 , Regulation of Energy Derivatives , by [author name scrubbed]; and CRS Report RS20560 , The Commodity Futures Modernization Act( P.L. 106-554 ) , by [author name scrubbed].