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 costs—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 1997–2001 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 earn—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.
Enron’s activities were complex, but it is not difficult to understand how the company’s executives misled investors, sometimes by circumventing accepted accounting guidelines and at other times by pushing those rules to the limit. The most important fact about Enron is how poorly the company was actually doing for several years in many if not most of the different branches of its business, even as Wall Street thought it was thriving. These were hardly the extraordinary managers the press claimed they were. Allan Sloan of Newsweek estimated, for example, that in the late 1990s it lost approximately $2 billion investing in broadband communications, $2 billion in a Brazilian utility, $2 billion in investments in water, and another $1 billion in the Indian electricity plant.2 In such failures, Enron’s executives showed astounding incompetence. Yet just before Enron restated its earnings downward last fall, sixteen of seventeen securities analysts whose work was tracked by Frank Partnoy, a University of San Diego law professor and a derivatives expert, had placed “strong buy” or “buy” recommendations on the stock. Only weeks before Enron declared bankruptcy in December, the highly influential debt-rating agencies—Moody’s, Standard & Poor’s, and Fitch/IBCA—considered Enron’s bonds and other debt “investment grade.”
Of Enron’s many dubious accounting schemes, the most important had to do with the off-balance-sheet partnerships. These allegedly independent partnerships have been widely used to help finance expensive capital investments, especially in the energy industry. Their use in “financial services firms is now very widespread,” according to Douglas Carmichael, an accounting professor at Baruch College in New York and former vice-president of auditing for the American Institute of Certified Public Accountants. The names of the Enron partnerships tell us something about the mentalities of the executives who set them up; some of the partnerships were named after characters from Star Wars, such as Chewbacca (Chewco) and Jedi (Joint Energy Development Investments). Others were called Braveheart, Raptor, and Condor.
The partnerships now in question were technically known as special-purpose entities. They had one desirable characteristic in common. According to longstanding accounting standards, if the sponsoring company owned 50 percent or less of the company, it did not have to put the debt or any losses of the partnership on its own financial statements. (Supposedly, the sponsoring company could not manipulate the partnership in its own interest if it owned only 50 percent of it or less.) Most enticing, however, these partnerships only required outside equity of 3 percent of their assets; the rest could be borrowed. Thus, if the sponsoring company could get a bank or other investor to lend the partnership money, it needed only to find a small amount of outside investment to enable it to keep the debt and losses off its own books. In truth, the 3 percent criterion was created by an accounting standards committee in 1990 but the SEC also declared that the requirement should at times be higher. It has taken on the status of law, but it is by no means legally binding.
Enron quickly made a mockery of the requirement for independence. Fastow and his subordinate, Mitchell Kopper, themselves ran the most important of the partnerships, a clear-cut conflict of interest. The Fastow appointment was approved by the board of directors. Kopper was partly chosen, on the other hand, because his position was low enough in the company that his role did not have to be publicly disclosed. Enron then worked out Byzantine methods to supply the needed 3 percent of equity; at times it simply failed to meet even this requirement. Finally, it got investors, including many of the most prestigious financial firms in the US, to lend money to the partnerships, often by guaranteeing repayment of the debt through the issuance of Enron shares. In reality, Enron and the partnerships were usually, in fact, one and the same. Truly independent partnerships would not have made investments on terms so favorable to Enron.
According to the Powers report, these partnerships enabled Enron to overstate profits and hide debt in two ways. First, Enron sold assets to the partnerships, thus creating profits for itself without having to record the liability the partnership incurred. Moreover, Enron often did this just before the end of a quarter, apparently in order to inflate profits being reported to Wall Street. It then frequently bought the assets back afterward, usually at a profit to the partnership, presumably with the intention of further manipulations before the next quarterly report.
More important, Enron created several partnerships which enabled the company to hedge against losses in its so-called merchant investments in other companies. One of these investments was in Rhythms Net Connections, a red-hot Internet service provider. Enron invested $10 million in the company in 1999, and its stock price soared, ultimately making Enron’s stake worth $300 million. Enron was able to record much of this run-up in the stock price as a profit. But it then entered an agreement with a partnership called LJM1, which required LJM1 to make up any loss to Enron if Rhythms fell in price. It is unlikely that any truly independent partnership would have agreed to such a contract without significant compensation. But Enron made it possible for LJM1 to agree by guaranteeing it against losses through promised injections of its own stock. Rhythms eventually went bankrupt but Enron avoided reporting its own losses in the company of, so far as I can determine, more than $100 million.
So successful was this partnership that in 2000 Enron entered into a similar but far larger hedging transaction involving the New Power Company, which sold electricity in the wholesale and retail markets, and was also soon to fail. Enron hedged several other investments in this way, creating a series of partnerships known as Raptor, but Rhythms and New Power accounted for most of the reported losses and the restatement of its earnings last fall. What essentially happened was that as Enron stock and the shares of the merchant investments like Rhythms also fell, these partnerships could not meet their obligations or keep up the necessary equity capital. In fact, the investment structure had gone bad earlier in the year, and executives fashioned a temporary fix that might have worked had Enron stock stopped falling. Also, it appeared that the SEC requirements to maintain the independent status of other relevant partnerships were never met. Andersen and Enron management finally agreed they had to report publicly the losses and reduction in stockholder equity.
The $1 billion that the Powers report found missing is not necessarily all that Enron has lied about. It alone accounts for one third of Enron’s after-tax profits between 1997 and 2001. But Frank Partnoy, who wrote an excellent book about his experiences in Morgan Stanley’s derivatives operations, called F.I.A.S.C.O.,3believes Enron’s profits were widely inflated in operations that the Powers commission did not investigate. He says, to take one example, that traders at times overstated the value of their derivatives contracts and energy contracts. The methods by which they calculated these values, which often required estimates of prices many years into the future, were not disclosed.
In another well-publicized example of taking profits it had not earned, Enron sold part of its joint venture with Blockbuster, the retail video chain, to a partnership called Braveheart, which was set up to sell videos on demand to consumers. Braveheart in turn borrowed $115 million from a bank, guaranteed, it seems, by Enron stock. Enron entered $110 million or so of expected profit on its books, but the profit never materialized. The Financial Times of London reported that the company frequently took profits on long-term service contracts well before future expenses were known.4
Information thus far available strongly suggests that Jeffrey Skilling and Andrew Fastow were the authors of the most audacious of these schemes. Skilling, in fact, may eventually have officially stayed aloof and given full charge to Fastow, who was promoted to chief financial officer. Skilling testified before Congress that he had no knowledge of accounting irregularities at these partnerships, although other executives claim he was informed of them. In many corporations one strong-headed executive who has the support of his superiors can readily cajole and coerce subordinates. Corporations are, after all, not democracies.
But many still wonder why a company with so many sophisticated executives believed they could get away with crassly deceptive practices. The answer may lie in the conventional psychology of gamblers. If you roll the dice enough, you may win. Skilling and Fastow probably believed, at least up to a point, that eventually some of their “new economy” investments would blossom and bail them out. Then, perhaps they told themselves, they would make everyone whole.
A second explanation is more disturbing. It seems that a great many others were doing the same thing. Why did Enron’s accountants and lawyers approve of these activities? Wall Street is now ridden with fears that other companies have overstated earnings because of similarly misleading accounting practices that were devised by the major accounting and law firms. The SEC is investigating Global Crossing. The stocks of companies such as World.com, Reliant Services, the Irish drug firm Elan, and even General Electric have been falling in price for fear they will have to restate earnings as scrutiny of corporate books increases. BusinessWeek reports that the former chief accountant of the SEC, Lynn Turner, estimates that investors have seen company stock prices fall by $200 billion as earnings were restated because of what were later deemed accounting errors.5 He finds the number of companies that have had to restate earnings has doubled since 1997. Economists at the Levy Forecasting Center in Chappaqua, New York, believe that profits nationwide may be overstated on average by 20 percent.
Meantime, Washington itself approved more and more lenient accounting techniques that enabled firms to estimate future profits liberally, especially when the profits came from trading in derivatives. The Powers report is especially harsh on Arthur Andersen. It states that Andersen “did not communicate the essence of the transactions in a sufficiently clear fashion to enable a reader of the financial statements to understand what was going on.” The Powers report also finds that Andersen had an integral part as consultants in creating the Raptor partnerships, earning nearly $6 million in fees on these and related partnerships alone.
Similarly, the Powers report finds that Enron’s company lawyers, Vinson & Elkins, were consulted frequently for advice and legal approval of controversial operations. One episode is particularly revealing. In August, Kenneth Lay received an anonymous letter warning that the company’s accounting was highly misleading. A week later, the author of the letter, Sherron Watkins, an Enron vice-president, came forward. Lay wanted to investigate her claims and management and the board agreed that Vinson, its own lawyers, should undertake it. Unsurprisingly, Vinson found that Watkins’s charges were not valid. In retrospect, almost all of them turned out to be true.
Can we expect serious reform of the practices that brought Enron down? “If it doesn’t happen now, it will never happen,” says Douglas Carmichael of Baruch College. The most remarkable fact that I found in the Powers report is that the Chewco and LJM1 partnerships largely came undone only because they failed to meet certain minimal capital standards. Had these partnerships met the 3 percent capital requirement, many of the losses might never have been revealed by Enron, and the sham could have continued. The 3 percent requirement for special-purpose entities, never written into law, has given rise to overstated profits and hidden losses across America, and it is clear that it must be changed.
But effective leadership for reform does not so far seem likely to come from the White House. The original reaction from President Bush’s main economic adviser, the Harvard-trained Lawrence Lindsey, was pride that nothing was done by the government to save Enron. Its failure was proof of “the genius of capitalism,” he said. Treasury Secretary Paul O’Neill made a similarly fatuous remark. A genuine advocate of free markets should have been furious about the misleading information that Enron produced and its abuse of basic trust with its investors. Laissez-faire economists should be among the most ardent proponents of accurate information and “transparent” business operations.
In late January, President Bush said that such activities as those practiced by Enron cannot be tolerated. But the reforms the administration has thus far proposed are weak, including the SEC’s proposals for accounting oversight, new regulations for 401(k)s, and minimal disclosure liabilities for executives. Such foot-dragging on reform, however, has not been limited to the Bush administration. After the spectacular collapse of the hedge fund Long-Term Capital Management, in 1998, President Clinton’s Treasury Department did not advocate serious new regulations that might have improved disclosure about the trading of the same sort of securities that Enron traded. As chairman of the Federal Reserve, Alan Greenspan has not demanded stronger disclosure requirements. The former chairman of the Securities and Exchange Commission, Arthur Levitt Jr., has described being stymied by both Democrats and Republicans when he proposed more regulation of accountants. During the 1990s, both Republicans and Democrats actively reduced requirements that corporations disclose accurate information. They passed legislation in 1995 to shield executives from investor lawsuits. They kept accountants from adopting stronger disclosure requirements concerning the stock options they issue employees and how they account for so-called goodwill in mergers. In 2000, they passed legislation completely deregulating trading in over-the-counter energy and other derivatives.
As for economists, many have advocated as a matter of principle that capital markets throughout the world provide full and accurate information. Some were quick to blame the Asian financial crisis in 1997 on poor financial reporting, as were many on Wall Street, in the international lending institutions, and in Washington. In light of recent events, American financial institutions look more than a little hypocritical.
Four sources of corporate irresponsibility require attention. Accounting standards and practice must be improved. Douglas Carmichael agrees that one of the most important reforms would be to strengthen regulations concerning special-purpose entities such as Enron’s partnerships. He also argues, as do many others, that a statutory body is needed to oversee and enforce auditing standards. In early February, Congress seemed more actively concerned with reforming accounting practices than with taking other measures.
Pension reforms are also urgent. Employees should be encouraged to diversify their holdings. So many Enron employees saw their retirement 401(k)s wiped out that one would think their losses would raise questions about recent proposals to privatize Social Security, which would require that people manage their own investments as well. We can expect there will be some reform in pension investment practices, but it will probably be modest.
What should be clear by now is that derivatives must be fully regulated. The economist Randall Dodd, who runs the Derivatives Study Center in Washington, argues that they should be subject to the same requirements as any other securities: those who trade in them should be obliged to reveal the sources of the capital on which they are based, to report transactions accurately, and to register as market participants. He says several new regulatory bills are being drafted in Congress, but he thinks the chances of passage are no better than 50 percent. In my view, his estimate is high.
The most difficult corporate activities to monitor are those that involve conflicts of interest. Congress may well require that accountants separate some consulting practices from their auditing practice. But these are not the only conflicts of interest that the Enron scandal has brought to light. In particular, Wall Street analysts, who advise investors on companies, often work for investment houses that also earn hundreds of millions of dollars raising money for those same companies. All benefit by keeping stock prices high and financial statements looking healthy. Meantime, the business press, and in particular the influential financial news programs on television, provide little or no skepticism concerning the pronouncements of these analysts, many of whom are obviously influenced by the interests of their companies. One analyst made a credible case that he was fired early last year because he urged his clients to sell Enron.
The basic question arising from the Enron scandal is whether accounting statements can be required to reflect the true economic condition of the companies. In many companies, including Enron, there was at best a pretense of this, and often not even that. Perhaps the best overall reform, as Partnoy suggests, might be to adopt legislation to make corporations, their officers, and their directors legally liable should the general requirement that disclosure must reflect the economic reality of a company be violated.
Whether there will be sufficient public pressure to bring about such a change seems doubtful. The most powerful forces in Washington and Wall Street seem inclined to ignore the depth of the flaws in the financial system that have been revealed by Enron’s collapse. It is still far from clear just what could persuade Congress to seriously enforce the ethical standards that Enron betrayed.
—February 13, 2002
March 14, 2002