Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp.
Widely promoted as one of the great corporations of a new age, the Enron company has turned out to be largely, and perhaps even mostly, a creation of accounting gimmickry. But the scandal of its collapse is not an isolated example of a single company run amok. The most serious of Enron’s activities could not have been undertaken without the approval, encouragement, and at times complicity of many of the most prestigious independent accountants, lawyers, commercial and investment bankers, security analysts, and debt-rating agencies in the nation. They also could not have been carried out without an unusually lax attitude in Washington and elsewhere toward even the most basic securities regulations and disclosure requirements. More than any other recent event, Enron’s collapse has made it apparent that there is something deeply wrong with the way public companies operate in America’s financial markets, and with the way information is manipulated with little respect for the interests of clients or customers and for the spirit of the law, not to mention elementary standards of honesty.
This is hardly a foundation on which a strong economy can be built. Systematically misleading information encourages tens of billions in wasted investments; it also promotes and sustains inefficient companies, and even entire industries, and creates market speculation that can ultimately lead to widely damaging financial crashes, taking the innocent down along with the guilty.
Enron was formed in a merger fifteen years ago between two old-line natural gas pipeline companies, Houston Natural Gas and Internorth. But it had no intention of doing business as usual; nor should it necessarily have done so. Run by a soft-spoken economist, Kenneth Lay, it seized on the spreading deregulation of electricity and natural gas prices to transform itself into an entrepreneurial trader of energy, mostly electricity and natural gas, throughout the US and in many places around the world. In particular, it made inventive use of specialized financial instruments known as derivatives, which enabled it to hedge investments. If a company wanted to guarantee the price it would pay for electricity in 2004, Enron could write a contract with the company to provide electricity at that price. Enron could in turn hedge the guarantee by making a derivatives contract with another investor who would promise to sell electricity to Enron in 2004 at the same agreed-upon price. It eventually traded instruments like these based on everything from the value of fiber-optic cable capacity and newsprint to the weather.
In the eyes of Wall Street and the business press, Enron was a classic “new economy” company. It developed sophisticated financial trading technology, which impressed observers, and made intensive use of the Internet. Many of its ideas were sound and far-seeing. If derivatives in energy were traded legitimately, for example, it could help businesses and private energy users to reduce future uncertainties by enabling them to lock in costsâ€”even costs that would arise ten years later. The use of the Internet to trade derivatives could result in generally lower prices for, say, energy, by instantaneously matching many more buyers and sellers across wide geographical areas. Enron reported its earnings as nearly $1 billion in 2000, and its sales ranked it the seventh-largest company in America, according to Fortune magazine. Meantime, its stock rose to $90 a share, and its total market value to $70 billion. Fortune labeled it the most innovative company in the nation.
But beginning in early 2001, the stock price began to decline as Internet-related and telecommunications companies fell out of favor with investors. Unknown to most observers, or at the least ignored by security analysts, the falling stock price put increasing financial pressure on the company, which had liberally used its stock to guarantee loans and other liabilities and to sweeten deals for outside lenders and investors. Then Enron’s chief executive officer, Jeffrey Skilling, suddenly resigned in August, and rumors of financial trouble began to circulate. Finally, in October, Enron shocked Wall Street by announcing it was taking a $618 million loss. More quietly, that same day it announced that it was also reducing stockholders’ equity by $1.2 billion. The stock price fell rapidly. Later in October, the chief financial officer, Andrew Fastow, probably the leading figure in the alleged accounting manipulations, was asked to resign. In November, the company reduced earnings by another $600 million for the years 1997â€“2001 and added $2.5 billion to the debt on the company’s books. Enron rapidly lost customers for the derivatives it traded. In December, Enron at last filed for bankruptcy protection.
Rarely, if ever, had a company so big and famous expired so rapidly. It was the largest bankruptcy in American history. Several thousand employees lost their jobs almost immediately and many more thousands soon will. Enron’s stock is now worth only pennies a share. Many of the twenty thousand employees lost most of their retirement savings, having been encouraged by the company to buy Enron stock for their 401(k) plans. Pension funds throughout the country lost billions of dollars in their Enron investments.
As investigations got underway, J. Clifford Baxter, a former vice-chairman of Enron who resigned earlier last year and would have been asked to testify, committed suicide. Enron and its auditors, Arthur Andersen, were found to be shredding documents. In February, the chairman, Kenneth Lay, resigned from the board and refused to testify voluntarily before Congress. Increasingly, the prospect of criminal prosecution became likely. Subpoenaed to appear before Congress, several Enron officials refused to answer questions, citing the Fifth Amendment.
In view of Enron’s reputation as a financial trading company, it was only natural to assume that its losses had to do with activities in the loosely regulated energy contracts and financial derivatives in which it specialized. Derivatives, as has been seen, are financial instruments that “derive” from the underlying value of a stock, a bond, a barrel of oil, a unit of electricity, or apparently even the weather, among many other commodities and items of value. The derivatives give the owners the right to buy or sell these underlying assets at some time in the future at a given price. One of their great advantages is that an investor needs to put up little money to buy or sell a great deal of stock, oil, or any of countless other assets. But this also makes them risky, and many of the derivatives markets are completely unregulated.
Only after it filed for bankruptcy did Enron’s transactions begin to be understood more fully. While the company’s trading operations were manipulated to inflate profits, the most costly manipulations involved the use of off-balance-sheet partnerships in which some of Enron’s investments in new high-technology and energy companies at home and abroad were placed. The press initially concentrated on how much debt Enron had hidden off its balance sheet. What was more significant, however, was that by using these partnerships Enron reported profits it never made and covered up enormous losses. This was made clear by the three-person internal investigation commissioned by Enron’s board of directors in October and headed by William Powers Jr. of the University of Texas Law School. The Powers report found that between July 2000 and October 2001, Enron recorded $1 billion of profit it did not really earnâ€”or about 72 percent of the total profit it claimed during that period.
How much the executives of the Arthur Andersen accounting firm knew of Enron’s activities is still unclear, but lower-level Andersen employees complained to their superiors about improper accounting methods and Andersen shredded thousands of pages of documents relating to Enron. Andersen was not merely the auditor but also a consultant on setting up the partnerships under scrutiny. In retrospect, it is clear that even experts could not determine what was happening at Enron from financial reports or its filings with the Securities and Exchange Commission, which Andersen approved. That Enron paid almost no income taxes over five years by shuffling profits to different offshore locations was a minor detail compared to these other transgressions. For many companies, such tax avoidance has become conventional.
If the information now public is true, Enron’s questionable activities were not frauds that can be attributed to the “new economy”; they were simply frauds. Proving fraud requires that a jury believe beyond a reasonable doubt that Enron had intent to deceive. The shredded documents may well have contained such proof. I am told that the computers that generated these documents can also have data deleted from their hard drives with easy-to-acquire software. Many observers nevertheless believe that criminal penalties are likely, and that some executives are likely to talk in return for immunity. A lesser burden of proof in civil court may be easier to meet, and civil suits are now being filed by employees and investors across the country. The possibility that corporate directors and executives will be successfully sued may prove to be the most effective means to reform these practices.
Meantime, the Powers report makes clear that several officers had conflicts of interest and earned unconscionable fees for their work. The chief financial officer, Andrew Fastow, earned $30 million through these partnerships. A subordinate, Michael Kopper, earned $10 million. Executives also sold their company stock while they encouraged their employees to buy still more. Kenneth Lay cashed in more than $200 million worth, and was selling shares after internal complaints about accounting irregularities had been brought to his attention by an officer of the company. Potential financial troubles at the firm were known to executives well before they were known to the public. Citigroup, a major lender to Enron, decided to hedge its loans against possible default in late 2000 and early 2001, according to The New York Times.1
Enron gave money liberally to lawmakers and the press, contributing $6 million to political campaigns during the last decade, with three quarters of the money given to Republicans. Enron’s future depended greatly on the deregulation of energy markets. Lay was close to President Bush, and contributed, for example, three times as much to his Texas gubernatorial campaign as he did to his rival’s. Lay and Enron executives had several meetings with Vice President Dick Cheney and his energy task force while the administration was formulating a new energy policy. Cheney, with the endorsement of President Bush, has refused to turn over documents about the meetings to the General Accounting Office, which is now suing him. Cheney allegedly tried to help extricate Enron from an investment in an electricity plant in India. Lay may have influenced appointments to the powerful Federal Energy Regulatory Commission as well.
Enron also paid well-known journalists and political commentators unusually high sums as “advisers,” including Paul Krugman when he wrote for Fortune, William Kristol of The Weekly Standard, Irwin Stelzer, a frequent contributor to the Standard, who frequently praised Enron, and Lawrence Kudlow of CNBC. Kristol received $100,000 a year for his work as an adviser while others apparently received less. Well before Enron collapsed, Krugman, who once praised the company and then began to severely criticize it, voluntarily disclosed that he had received money from Enron. Enron also invited individual investment bankers to participate personally in its lucrative partnerships. It needed those bankers to help it raise millions from unsuspecting investors. Enron peddled influence in the same way it peddled gas, and seemingly made no distinction between the two.
February 8, 2002.↩
February 8, 2002.↩