Financial Disasters: The Enron Scandal Essay Example
Financial Disasters: The Enron Scandal Essay Example

Financial Disasters: The Enron Scandal Essay Example

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  • Pages: 9 (2201 words)
  • Published: November 17, 2017
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In late 2001, unethical financial activities were exposed in the Enron scandal.

In the 1990s, Enron and its accounting firm Arthur Andersen were implicated in a series of discoveries concerning fraudulent accounting practices. These irregular and potentially fraudulent practices ultimately led to Enron's impending record-breaking bankruptcy by November 2001. Despite efforts from Dynegy, a smaller energy company, their intervention proved futile, resulting in Enron filing for bankruptcy on December 2, 2001. This scandalous revelation greatly impacted Enron's stock value, causing it to plummet from over $90.00 to mere pennies.

This unforeseen turn of events had catastrophic consequences within the financial world as Enron was previously regarded as a reliable and trustworthy stock.

Enron's downfall occurred shortly after it was discovered that a majority of its profits and revenues originated from transactions with special purpose entities. These en


tities were limited partnerships controlled by Enron, causing a notable portion of the company's debts and losses to be concealed in its financial statements. In the 1990s, the US Congress enacted legislation to deregulate electricity sales, following a previous decision to do the same for natural gas.

Despite criticism, Enron and other companies prospered in the energy markets that were established. They managed to convince authorities to maintain the system, despite concerns about price volatility from producers and local governments. Enron's stock price soared to $80-90 per share in the late 1990s, with little regard for their lack of financial transparency. In July 2001, Enron exceeded analysts' expectations by reporting earnings of $50 billion, nearly triple the year-to-date figures, causing a 3-cent increase in their stock value per share. However, Enron's profit margin averaged around 2%, remaining relatively low.

Enron's stock price had plummeted

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by over 30% compared to the same quarter in 2000, causing growing concerns. The company confronted operational challenges, including logistical difficulties with its new broadband communications trading unit, the construction of the Dabhol Power project in India, and criticism for its alleged involvement in the California power crisis of 2000-2001. By August 2001, Enron's stock continued to decline, prompting CEO Lay to appoint Greg Whalley and Mark Frevert to positions in the chairman's office. Some observers believed that Enron's investors required reassurance because the company's business was complex and challenging to accurately convey through financial statements.

"It's challenging for analysts to determine Enron's profit and loss in a specific quarter," stated an analyst. Lay acknowledged the complexity of Enron's business and claimed that analysts would never obtain all the desired information. He attributed the business's complexity to tax strategies and position-hedging. Despite Lay's efforts, by September 9, 2001, a notable hedge fund manager observed that Enron's stock was under scrutiny. Skilling's sudden departure and Enron's opaque accounting practices made it difficult for Wall Street to assess the company accurately. Enron also admitted to using "related-party transactions" repeatedly, causing concerns about potential attempts to transfer losses from Enron's own balance sheet.

One troubling aspect of this technique is that some of the "related-party" entities were controlled by Enron's CFO, Andrew Fastow. On October 17, 2001, Enron announced negative third-quarter results due to one-time charges of over $1 billion. Enron management attributed the losses to investment losses and charges, including approximately $180 million spent on restructuring the troubled broadband trading unit. Kenneth Lay stated, "After a thorough review of our businesses, we have decided to take these charges to

clear away issues that have clouded the performance and earnings potential of our core energy businesses."

Some analysts, including David Fleischer at Goldman Sachs, were unnerved and questioned what would happen next. Fleischer, who was previously considered "one of the company's strongest supporters," stated that Enron's management had lost credibility and needed to regain it. According to Fleischer, they had to convince investors that the company's earnings were genuine, the company itself was legitimate, and that it would experience growth. Enron also claimed that the broadband unit alone was valued at $35 billion, but this assertion was met with skepticism. Todd Shipman, an analyst at Standard & Poor's, expressed doubt about anyone knowing the true value of the broadband operation.

Enron's stock price dropped significantly on October 22, 2001, falling from $26.05 to $20.65. This sudden decrease was caused by an ongoing investigation conducted by the Securities and Exchange Commission (SEC) into suspicious transactions carried out by Enron. These transactions were considered highly opaque and involved insiders.

To address this financial issue and reassure investors, Enron revealed several strategies it had employed. These strategies included using "share settled costless collar arrangements" and "derivative instruments that eliminated the contingent nature of existing restricted forward contracts." These strategies were implemented as hedges for specific merchant investments and other assets.

Many analysts were left feeling ignorant about Enron's business because of its arcane phraseology. Despite the crisis of confidence among observers and investors, Enron refused to provide more information about its unusual investment and accounting practices. CEO Jeffrey Skilling even used an expletive against a conference call participant who asked for balance sheet numbers to be released along with earnings. CEO Lay

stated that Enron would fully cooperate with the SEC investigation.

Enron management's attempts to seek new investment or a buyout were largely unsuccessful despite efforts. Figures like Warren Buffett and buyout firms, including Clayton, Dubilier & Rice, the Blackstone Group, and Kohlberg Kravis Roberts, were approached but declined or had fruitless discussions. Enron planned to provide a more comprehensive explanation of its business practices in an effort to regain confidence. However, investors remained concerned as Enron's stock value dropped to $7 and doubts emerged regarding the company's ability to find a buyer.

Dynegy, an energy trader based in Houston, TX, voted to acquire Enron for approximately $8 billion in stock at a discounted price on November 7. Chevron Texaco, which owned a quarter of Dynegy, agreed to provide Enron with $2.5 billion in cash. An upfront payment of $1 billion was made and the remaining amount would be given upon completion of the deal. In addition to taking on nearly $13 billion of debt, Dynegy also agreed to assume any undisclosed debt resulting from Enron's secretive business practices, which could be as high as $10 billion. The official confirmation of the agreement between Dynegy and Enron was announced on November 8, 2001.

Commentators noted the contrasting corporate cultures of Dynegy and Enron, as well as the straightforward nature of Dynegy's CEO, Charles Watson. Speculation arose as to whether Enron's problems were merely due to unintentional accounting errors. In November, Enron claimed that the billion-plus in "one-time charges" announced in October should have actually been $200 million, with the remainder being adjustments for long-standing accounting mistakes. Anxiety grew regarding the possibility of uncovering additional errors and restatements.

On November 9,

2001, Enron's earnings were majorly corrected with a reduction of $591 million for the years 1997-2000. This correction was mostly due to two special purpose partnerships known as "Jedi" and "Chewco". As a result, the profit for fiscal year 1997 was virtually eliminated with significant reductions in subsequent years. Despite this disclosure, Dynegy did not lose interest in purchasing Enron. Both companies eagerly awaited an official assessment of the proposed sale from Moody's and S. This assessment was considered crucial for Enron, as it would determine the impact on Dynegy and Enron's credit rating upon completion of the buyout transaction.

In addition, there were concerns about antitrust regulations that could lead to divestiture, as well as the differences in corporate cultures between Enron and Dynegy. However, both companies were aggressively pushing for the deal, and some observers were hopeful. Charles Watson was praised for his vision of creating a dominant presence in the energy market. During that time, Watson stated, "We feel [Enron] is a very solid company with plenty of capacity to withstand whatever happens in the next few months." One analyst referred to the deal as "a whopper" that was financially beneficial and strategically sound, providing immediate support to Enron's balance sheet. However, credit issues were becoming more critical. Moody's and S lowered Enron's rating, leaving it just above junk status. If Enron's rating were to fall below investment-grade, its ability to trade could be severely restricted due to the reduction or elimination of its credit lines with competitors. In a conference call, S confirmed that if Enron were not acquired, its rating would be downgraded to low BB or high B, which are

ratings considered to be at the lower end of junk status. Moreover, many traders had limited or completely halted their business dealings with Enron due to concerns about further negative developments.

During a presentation to investors in New York, Watson addressed concerns about Enron's business and acknowledged the need to address employee hostility towards management. This was due to Lay and other top officials selling millions of dollars' worth of stock before the crisis. The situation worsened when it was revealed that Lay could receive a $60 million payment despite his damaged reputation. Additionally, Enron employees suffered significant losses in their retirement accounts tied to Enron stock as its price plummeted 90% in a year. Some married couples who both worked for the company lost up to $800,000 or $900,000, effectively wiping out their savings plans.

Watson assured investors that he comprehended Enron's business accurately and guaranteed there would be no more unpleasant surprises. He believed that if there were no unexpected developments, the transaction would be extremely advantageous. Furthermore, Watson asserted that Dynegy's payment for the entire company was justified solely by Enron's energy trading division. The aftermath of Enron's downfall is uncertain in the long run; nevertheless, it has resulted in notable political consequences in the United States.

Enron's political contributions in the UK amounted to approximately US$7 million starting from 1990. During Clinton's presidency, Enron and Lay contributed around $900,000 to the Democratic Party. Democrats received $362,000 in soft-money donations from Enron between 1999 and 2000. From 1996 onwards, the Republican Party consistently received between 72% and 94% of annual American contributions, including significant support for George W. Bush's presidential campaign. The scandal had implications

that extended beyond Enron and its former affiliates.

The trial of Arthur Andersen LLP on charges of obstructing justice in relation to Enron revealed accounting fraud at WorldCom, leading to the telecommunications company's bankruptcy. This event also exposed other accounting scandals and corruption at high levels, as well as accounting errors and insider trading. While Enron's collapse was initially seen as the largest bankruptcy ever, it was overshadowed by WorldCom's downfall.

Former Enron CFO Andrew Fastow, who orchestrated the company's complex network of offshore partnerships and questionable accounting practices, faced indictment on November 1, 2002. A federal grand jury in Houston accused him of 78 counts including fraud, money laundering, and conspiracy. On January 14, 2004, he and his wife Lea Fastow - formerly an assistant treasurer - reached a plea agreement.

Andrew Fastow and his wife Lea Fastow have been sentenced for their involvement in the Enron scandal. Andrew will serve ten years in prison and must forfeit $23.8 million, while Lea will serve a five-month prison sentence followed by one year of supervised release, including five months of house arrest. Both individuals have agreed to testify against other Enron executives as part of their cooperation agreement.

Prior to them, Ben Glisan Jr., the former Enron treasurer, became the first person implicated in the scandal to be incarcerated. He confessed to one count of conspiracy related to security and wire fraud.

John Forney, a former energy trader, is facing indictment on charges of conspiracy and wire fraud. He gained recognition for creating innovative strategies like the "Death Star." The trial for his case was scheduled to occur on October 12, 2004. His supervisors, Timothy Belden and Jeffrey Richter, have

already confessed to conspiring in wire fraud. They are presently cooperating with prosecutors in investigating the scandal. On February 11, 2004, the FBI arrested Jeffrey Skilling. Kenneth Lay has also been indicted by a federal grand jury on July 7, 2004, for his involvement in the scandal.

On July 9, the defendant pleaded not guilty. The jury delivered the verdicts in the Lay and Skilling trial on May 25, 2006. Skilling was found guilty of 19 out of the 28 counts pertaining to securities fraud and wire fraud, but was acquitted of nine counts, including insider trading charges. As a result, he was sentenced to serve a prison term lasting for 24 years and 4 months.

Lay was found guilty of securities and wire fraud on all six counts and could have been sentenced to a maximum of 45 years in prison [86]. However, before his sentencing, Lay passed away on July 5, 2006. About a week later, the body of Neil Coulbeck, who had the potential to be an Enron witness in the US, was discovered dead in a park in north-east London [1]. The US case implicates Coulbeck and others for conspiring with former Enron CFO Andrew Fastow. In total, sixteen individuals confessed to their crimes at the company while five others, including four ex-Merrill Lynch employees, were convicted after trial.

Eight former Enron executives gave testimony against Lay and Skilling, including Fastow who was the star witness. Another executive, Kenneth Rice, the former chief of Enron Corp.'s high-speed Internet unit, also cooperated and provided testimony that aided in the conviction of Skilling and Lay. In June 2007, Rice was sentenced to 27 months.

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