ENRON CORPORATION CASE STUDY
Introduction
Enron Corporation was formed in 1985 from a merger between Houston Natural Gas Company and Omaha-based InterNorth Incorporated. Enron was once the seventh-largest corporation in America and was named the ‘America’s Most Innovative Company’ by Fortune for 6 years consistently. The corporation that took 10 years to build up to 60 billion dollars in value took less than a month to go bankrupt. Enron had accumulated approximately $598 million in losses, $628 million in debt. (ColdFusion, 2019), billions of dollars stolen, thousands of jobs lost, dozens of convictions, one suicide and a public display of corporate greed.
It was headed by Kenneth Lay as the CEO and Chairman of the corporation. Lay appointed Jeffrey Skilling to lead the organization and Andrew Stuart “Andy” Fastow as the CFO.
Role Of Financial Instruments In Downfall Of Enron.
In order to finance their corporation and subsidiaries, Enron was able to attract investors and trading partners through offering their reputation as the most innovative company, credit, expertise in energy, political backup and praise because of its expansion and ambitious projects. (Company Man, 2017).
Enron knew as long as the company met or exceeded its endless expectations their stock price would keep rising. Enron’s executive management committee, therefore, violated the accounting regulations under Generally Accepted Accounting Principles (GAAP) to hide losses and debt (Lemus, 2014) in order to cover up the true value of their corporation.
This is how;
1. Off-Balance Sheet
Enron understood that the information delivered to the market participants has a direct effect on the returns that can be made. They used of special purpose vehicle (SPV) known as a special purpose entity (SPE) to hide large debts and toxic assets from creditors and investors. They set up side companies in which they pushed their debt over to them hence solving the ‘debt problem’.
They also colluded with JPMorgan Chase, Citigroup bank which helped report loans as cash flow from operations for the period 1992–2001 (B. Aven, 2015). Also, Arthur Andersen who audited their financial statements.
2. Mark-To-Market
MTM is based on ‘fair value’ not the ‘actual value’ so it can be manipulated by allowing organizations to log estimated profits as actual profits as in the case of Enron.
An example is the case of the partnership of Enron broadband services and Blockbuster where they entered or logged expected earnings based on the expected growth of the VOD market. Or in the case of the Indian power plant where immediately after building the power plant, Enron claimed the profits in its books even when the company had not even made a dime.
3. Futures Speculation
Enron’s executives believed that their stock would continue to appreciate. Enron being the counterparty and in total control of their assets and trading enabled them to manipulate the prices of their stocks to fit their desire.
4. Manipulation of Derivatives
Enron did this by hiding the losses in the derivative section (loans were presented in the form of prepaid commodity swaps) (Konar, 2018).
Some reasons why fraudulent transactions happened:
1. Gas and electricity market deregulation.
2. Absence of accounting standards for prepaid commodity swaps. (Konar, 2018)
3. Political ties to the then president of America George W. Bush
Market Effects Due To The Rise And Fall Of Enron.
1. Positive.
a. Stricter regulations were set to govern the market and auditors now have a stricter independence role
b. Sarbanes-Oxley reforms that make sure that CEOs and CFOs have to specify the signatures on their financial statements so that they can not deny they ever saw them. (Goodell, 2018)
2. Negative
a. Thousands of employees lost their jobs.
b. Shareholders saw their investments shrink to a fraction of the previous value. (Leg, 2020)
c. Auditors who survive by reputation like Arthur Anderson did not survive the scandal. This means investors avoid companies audited by them, which is bad for business.
Risk Mitigation Techniques To Minimize Enron Risk Profile
1. Strengthen Rules And Regulations Governing The Board.
This can be done by adopting key aspects of the private-equity governance model to ensure that they fulfil their oversight responsibilities. (Lagace, 2002).
In private-equity governance, boards are “proprietors or representatives that means they have a strong sense of ownership, clear shared expectations of risk-return and the timeline that frames their investment” (O’Brien, 2008).
2. Up-to-date accounting standards. (Konar, 2018)
For example, adopting International Financial Reporting Standards (IFRS) instead of the US GAAP. IFRS has set rules so that financial statements can be consistent, transparent and comparable around the world.
3. Compulsory Disclosure Of Financial Statement
This is to promote openness and transparency during the entire reporting period while promoting information aggregation and coordination. This will also allow investors and creditors to make informed decisions.
4. Implementation of Fraud Detection Systems
These will basically help reduce misinformation from the corporations.
Conclusion
Enron downfall and collapse led to a more regulated and open financial market with information being key to good investments around the world.
In financial markets, risk is unavoidable but can be reduced or managed or mitigated. Ways in which the investors, creditors and the corporation could have mitigated their risks which came with the fall and collapse of Enron have been mentioned above.
References
Lemus, Edel. The Financial Collapse Of The Enron Corporation And Its Impact In The United States Capital Market. Global Journal Of Management And Business Research., 2014,
Legese, Alem. “The Role Financial Instruments Played In The Downfall Of Enron”. Studocu,2020.
Konar A. The Role of Financial Markets in the Case of Enron . Bulletin of the South Ural State University. Ser. Economics and Management, 2018, vol. 12, no. 4, pp. 41–44. DOI:10.14529/em180405
ColdFusion. Enron — The Biggest Fraud In History . 2019.
Company Man. The Enron Scandal — A Simple Overview . 2017.
Aven, B. L. (2015). The paradox of corrupt networks: An analysis of organizational crime at Enron. Organization Science, 26(4), 980–996.
