The Enron scandal and the Sarbanes-Oxley-Act

Table of contents

1. Enron’s business

2. Timeline of the collapse

3. Charges against Enron
3.1 Off-the-books activities
3.2 Conflicts of interests and lack of supervision by the Board of Directors
3.3 Compensation of the company’s management
3.4 Lack of independence of the Board and the auditors

4. The Sarbanes-Oxley Act of 2002

5. Costs and benefits of the Sarbanes-Oxley Act

Appendix

Sources

Preface

The downfall of Enron was one of the most momentous corporate scandals and bankruptcies in the history of the United States of America. This assignment deals with the timeline of Enron’s collapse and introduces the main charges against the company and it’s Board of Directors. Ultimately, the Sarbanes-Oxley Act will be presented as major legislative response to this corporate fraud, before concluding with weighing the costs and benefits of this large-scale legislative project.

1. Enron’s business

In 2001, the year of the scandal, Enron Corporation ranked number seven among the largest companies of the United States of America. Enron employed more than 21,000 people all over the world and achieved revenues of more than USD 100 billion in 2000.

Initially, Enron started out as a traditional energy supplier - running pipelines and power plants. But within a couple of years, the company changed its business fundamentally. They engaged in broadband information technology and formed a trading business which was involved in dealing with delivery contracts for oil, gas and electricity. Enron traded those contracts like securities or commodity futures.^[1]

The aim of this business model was to minimize the uncertainty and risk involved in changing gas prices. Therefore, Enron created the so-called Gas Bank. Enron’s plan was to become an intermediary between producers of natural gas and consumers. Producers signed contracts with Enron and supplied the company with natural gas. On the other side of the deal, costumers also signed long-term contracts with Enron. Enron generated its earnings from the spread between their purchasing price and their selling price. Just like the profit margin of a bank is the spread between lending and deposit interest rates. This model would decrease the risk and volatility inherent in the spot market - for Enron, their producers and their customers.

Although this business model was often described as a triumph, Enron had to face problems from the beginning. The company was capable of convincing consumers to sign long-term delivery contracts for natural gas. But the problem was to induce producers to clinch the deal. Natural gas prices were low at that time and producers hoped for better times. Therefore, they denied committing themselves to long-term contracts with Enron at reasonable prices. Consequently Enron had to purchase the gas on the sport market at higher prices in order to meet their contractual obligations. To close the gap between supply and demand, Enron decided to prepay the producers - or in other words they gave credits to oil producers spurring them to sign long-term contracts.

Another major factor that was essential to Enron, was the mark-to-market accounting. This was totally different from the traditional historical cost accounting companies used to conduct. The main variation to historical cost accounting is that Enron was enabled to book the complete value of a contract or deal as soon as the deal was closed. For instance, if Enron clinched a ten-year-contract for supplying gas to a company, they were entitled to book the earnings of that deal immediately as income - regardless when or even if the cash flow is actually generated. Moreover, if the value of a contract changed during its maturity, appreciation or depreciations were disclosed as further earnings or losses. Since a gas supply contract might have maturities of ten or even twenty years, it is very hard to estimate the value of such a deal with unforeseeable cash flows in the future. So mark-to-market accounting enabled Enron to influence its business figures just as they needed them. This deceived investors and analysts. Disclosing assumed future cash-flows immediately, implied an enormous growth of the company. This made analysts and consequently investors fall for Enron stocks and accelerated Enron’s stock market rally. Despite the fact that it was never certain when or even if Enron was going to gain the disclosed earnings. Nonetheless, the Securities and Exchange Commission entitled Enron to conduct mark-to-market accounting in the early 1990s.^[2]

2. Timeline of the collapse

In February 2001, the auditors of Arthur Andersen had a meeting, during which they raised doubts concerning the soundness of Enron’s Special Purpose Entities (SPE) and the company’s accounting practices. Their main concern was that Enron’s Special Purpose Entities had to be independent from Enron in order to be treated as off-balance-sheet entities. But Arthur Andersen eventually revealed that this was not the case for every SPE, since some of them were managed by Enron managers. For example, the Chief Financial Officer of Enron, Andrew Fastow, was at the same time, general partner in an off-balance-sheet partnership.^[3]

On 14 August 2001, Jeff Skilling, the Chief Executive Officer of Enron resigned from office. This step was unanticipated and triggered severe concerns among investors whether Enron has substantial problems. Skilling’s quitting caused a further decline of Enron’s stock (chart 1, appendix) . Therefore Enron tried to convince investors that everything is sound and stable at their company and that there are no problems.^[4] But at the very same time, Sherron Watkins, a vice president of Enron, anonymously informed Kenneth Lay, Enron’s Chairman, about her fears of a looming scandal and irregularities in the company. She voiced her doubts concerning the Special Purpose Entities, claiming that not all of them were factually independent from Enron. The problem with the SPEs was that Enron removed debts from its balance sheet by hiding them in the SPEs. The SPE then generated income that Enron could disclose on its own income statements. Since these entities were funded with Enron’s stocks, they could enhance their value when the stock prices were rising. But since Enron’s stocks were declining, the partnerships could no longer generate income cash flows for Enron. The result was that Enron suddenly had sustainable liquidity problems.^[5]

Sherron Watkins then voiced her worries to the auditors of Arthur Andersen and approached Kenneth Lay for a private conversation. During this period, Kenneth Lay always tried to appease investors and to reestablish their confidence.^[6]

In the early fall of 2001, Arthur Andersen gradually realized that there were major problems and demanded Enron to adjust their accounting practices for their Special Purpose Entities. At the same time, employees at Andersen’s started to destroy documents of their audits at Enron.^[7] In October 2001, Enron’s stock market price was further declining. Since Enron was now forced to disclose their off-balance-sheet entities, their financial strength was declining rapidly. Consequently, they had to declare a quarterly loss of USD 618 million and disclosed that they had to adjust the value of their assets by USD 1.01 billion. Enron swiftly lost USD 1.2 billion in market capitalization.^[8] Furthermore, Enron had to announce that the Securities and Exchange Commission has already started investigations regarding conflicts of interests between the Special Purpose Entities, the Directors of Enron and the company itself. The stock market price was further declining: from more than USD 80 in February to just USD 15 in October 2001.^[9] Enron tried to fight back during October and November 2001, but credit rating agencies reduced the company to junk-bond grade. That implied that Enron straight away had to pay back USD 4 billion of its USD 13 billion debts. The share price dropped below USD 1.^[10] On 2 December 2001, Enron declared bankruptcy. Within a few months, a company asserting that it would have assets worth USD 62 billion was ruined.^[11] The subsequent shockwave was enormous, due to major exposures to Enron of numerous companies and banks (Table 1, appendix)

In the aftermath of the downfall of Enron, a number of managers and Directors were charged and sentenced. Andrew Fastow, CFO of Enron, was sentenced to six years in prison in 2006, Kenneth Lay, CEO and Chairman was convicted, but died before being sentenced^[12] and Jeffrey Skilling, CEO, was punished with a 24-year prison sentence.^[13] Enron’s auditing firm Arthur Anderson subsequently lost most of its clients and had to set off most its employees. Moreover, the firm was found guilty of hindering investigations by destroying audit documents.^[14]

[...]

^[1] Cp.: United State Senate: The Role of the Board of Directors in Enron’s Collapse, 2002, p.6-7

^[2] Cp.: McLean, Bethany; Elkind, Peter: The Smartest Guys in the Room, New York 2003, p. 33- 42

^[3] Cp.: http://news.bbc.co.uk/hi/english/static/in_depth/business/2002/enron/timeline/8b.stm (30.12.2208)

^[4] Cp.:http://news.bbc.co.uk/hi/english/static/in_depth/business/2002/enron/timeline/9.stm (30.12.08)

^[5] Cp.:http://news.bbc.co.uk/hi/english/static/in_depth/business/2002/enron/timeline/9b.stm (30.12.08)

^[6] Cp.:http://news.bbc.co.uk/hi/english/static/in_depth/business/2002/enron/timeline/9.stm (30.12.08)

^[7] Cp.:http://news.bbc.co.uk/hi/english/static/in_depth/business/2002/enron/timeline/10.stm (30.12.08)

^[8] Cp.:http://news.bbc.co.uk/hi/english/static/in_depth/business/2002/enron/timeline/10b.stm (30.12.08)

^[9] Cp.:http://news.bbc.co.uk/hi/english/static/in_depth/business/2002/enron/timeline/10c.stm (30.12.08)

^[10] Cp.:http://news.bbc.co.uk/hi/english/static/in_depth/business/2002/enron/timeline/11c.stm (30.12.08)

^[11] Cp.:http://news.bbc.co.uk/hi/english/static/in_depth/business/2002/enron/timeline/12.stm (30.12.08)

^[12] Cp.: http://www.nytimes.com/2006/09/27/business/27enron.html (30.12.08)

^[13] Cp.: http://www.nytimes.com/2008/04/03/business/03enron.html (30.12.08)

^[14] Cp.: http://news.bbc.co.uk/2/hi/business/2047122.stm (30.12.2008)