When most people think of securities fraud and corporate misconduct, they will often associate Enron to these ideas. This is because it went from being the tenth largest company in America to one the biggest bankruptcies in U.S. history. On surface, everything appeared to be fine. Until it was disclosed, that the firm was running out of cash and the executive officers were unloading their stock. (Eichenwald, 2005)
This raised concerns that something more was happening behind the scenes. To fully understand what occurred requires carefully examining the firm itself, the effects it had on the legal system, the lasting impact on stakeholders and conducting an analysis of the situation. Together, these elements will highlight the various securities laws that were violated and the way case changed corporate governance going forward. (Fox, 2004)
The Circumstances at Enron
Enron was founded in 1985. This occurred after Houston Natural Gas merged with Northern Natural Gas. The combined companies were taking advantage of deregulation inside the natural gas industry and electricity markets. At the heart of their strategy, was to create a business model to purchase these assets and then sell them to customers for a sizable profit margin. This became a concept known as energy trading. (Eichenwald, 2005) (Fox, 2004) (Fusaro, 2002)
However, major problems began to develop when they would speculate that prices were moving higher and went in the opposite direction. This caused the company to experience tremendous losses and it created uncertainty in their business model. Moreover, the firm was aggressively purchasing new businesses that were deregulating in various parts of the world. They also began to construct facilities in order to meet the growing demand in countries (such as: India) for electricity and natural gas. (Eichenwald, 2005) (Fox, 2004) (Fusaro, 2002)
To address these issues, Ken Lay and Jeff Skilling created a way to enhance their balance sheet called marked to market accounting. This is when the firm would go into the marketplace and show that a particular asset was worth less than it actually was. The way that this was accomplished is they would make it appear as if they were taking the loss. (Eichenwald, 2005) (Fox, 2004) (Fusaro, 2002)
Instead of reporting this to their shareholders, they would hide them in off the books investment vehicles known as special purpose entities. This is where they would send assets that were unprofitable and offer anyone who invested in them with Enron’s common stock as a form of compensation. In the 1990s, this helped them to increase the price of the stock and make the firm appear to be financially solvent. (Eichenwald, 2005) (Fox, 2004) (Fusaro, 2002)
After, the economy began to slow in early 2000, is the point that this strategy backfired. This is because the stock was declining and they were passing on more of their losses to these special purpose entities. To compensate investors, Lay and Skilling offered them with greater numbers of shares. At the same time, they continued to claim how the company was fiscally strong. Yet, the upper management knew what was happening and began selling their stock. (Eichenwald, 2005) (Fox, 2004) (Fusaro, 2002)
In August 2001, Sharon Watkins (an employee at the firm) questioned these practices and reported to regulators that the company was on the verge of financial ruin. This resulted in an investigation by the Securities and Exchange Commission (SEC). When this happened, it was only a matter of time until these losses were reported to Wall Street and the price of the stock imploded. Unable to find a buyer or receive any kind of additional financing, the company was forced to file for bankruptcy in late 2001. (Eichenwald, 2005) (Fox, 2004) (Fusaro, 2002)
The Effects of Enron on the Legal System
The biggest problem with Enron from a legal perspective; is that the firm was in violation of the Securities and Exchange Act of 1934. This requires that all firms must disclose any kind of adverse material changes in their financial situation to investors and regulators. The fact that they were hiding these losses was an attempt to defraud the public. Moreover, the false reports meant that the information submitted to the SEC was considered to materially misleading (which is also in violation of these provisions). (Farrell, 2009) (Niskanen, 2007)
After the bankruptcy, the federal government went after executives who were a part of the cover up. Their basic strategy was to use them as confidential informants. This meant that they would threaten to fully charge these individuals to the fullest extent of the law (unless they cooperated). These tactics resulted in individuals such as Andrew Fastow (the CFO) testifying against Lay and Skilling. (Farrell, 2009) (Niskanen, 2007)
These techniques allowed federal prosecutors to piece together what happened and determine the roles of Lay and Skilling. This resulted in both men being charged with 28 counts of securities fraud, wire fraud and insider trading in 2006. The trial occurred inside Houston Federal Court. The evidence was based on the testimony of eight former employees who testified against them. At the same time, financial documents were utilized to show how these individuals orchestrated the fraud and knew about what was happening. This evidence was used to illustrate the way both men were directing what was occurring. Skilling was subsequently convicted on 19 counts of insider trading, securities fraud and wire fraud. While Lay, was convicted of 10 counts of securities fraud, wire fraud and making false statements. Skilling was sentenced to 20 years in prison and order to pay $810 million in restitution / fines. Lay died of heart attack after the trial. The decision against him was vacated in light of these circumstances. (Farrell, 2009) (Niskanen, 2007)
The Lasting Impact of Enron on Stakeholders
The lasting impact of Enron is that securities laws were changed in the aftermath of the scandal. This resulted in the passage of the Sarbanes-Oxley Act. It stiffened penalties for someone who is making misstatements to the public. At the same time, it required that CEO and CFO to certify under oath that the financial information they submitted is factually accurate. This has forced firms to spend more of their budget making sure they are in compliance with the law and improve their reporting standards. The economic impact is that a variety of firms are becoming hesitant about going public and will often choose to remain as private entities. Moreover, foreign-based companies are deciding to list on other stock exchanges (such as: London) in order to avoid the challenges with the new law. (Baur, 2009)
An Analysis of Enron
The main reason why Enron occurred is because regulations did not keep up with changes in the financing utilized by corporations. At the same time, the rising stock market made it easy to hide these losses. This created a situation where management could exploit these variables for their own benefit. The best way to prevent these problems is to have regulators aggressively investigating these issues and ensure that they have higher levels of funding. If this had taken place, the fallout from the Enron affair would have been considerably less. (Baur, 2009) (Niskanen, 2007) (Fox, 2004)
Baur, A. (2009). The Enron Scandal. Munich: Grin Verlag.
Eichenwald, K. (2005). Conspiracy of Fools. New York, NY: Broadway Books.
Farrell, O. (2009). Business Ethics. Mason, OH: South Western.
Fox, L. (2004). Enron the Rise and Fall. Hoboken, NJ: Wiley.
Fusaro, P. (2002). What Went Wrong at Enron. New York, NY: Wiley.
Niskanen, W. (2007). After Enron. Latham MD: Rowan and Littlefield.
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