December 2nd, 2001 was one of the darkest days in the history of The Wall Street, one of America’s biggest energy company declared bankruptcy, investors lost billions of dollars, the company’s share price plummeted to $ 1 per share after being traded at $ 90 pe
December 2nd, 2001 was one of the darkest days in the history of The Wall Street, one of America’s biggest energy company declared bankruptcy, investors lost billions of dollars, the company’s share price plummeted to $ 1 per share after being traded at $ 90 per share not too long ago. To this day, many wonder how a company so big and powerful capsized overnight? How did it manage to hoodwink the regulators and Wall Street community?
In this article let us discuss the fall of Enron Corporation, its creative accounting systems through which it managed to hoodwink investors and the watchdog, it’s phenomenal rise in Wall Street, related party transactions, energy deregulation, special purpose entities and the role of management in its collapse.
Formed in 1985, by Kenneth Lay, an American businessman after merging Houston Natural Gas and InterNorth, it was considered one of the most innovative companies before it crashed dramatically. The company continued to operate its power plants and gas lines, but it became better known for its trading businesses. Deregulation of the energy markets allowed it to place bets on future prices, and Enron was poised to take advantage of it, the company managed to create an internet based trading platform that quickly became the largest e-commerce website in the world. It earned revenue of $ 880 billion in just two years after launching Enrononline. Enron’s push to force utilities into the Internet age with its online trading systems, at record profits, became an epic tale of the dot-com boom. From 1990 to 1998 its stock rose to a whopping 311 percent, it was rated as the most innovative company in America in Fortune’s most admired companies survey.
The Collapse
Enron’s CEO Jeffrey Skilling replaced the conventional system of accounting followed in the company (which listed the actual costs of supplying gas and actual revenues received from it in its books) with market-to-market accounting, which required that once a long term contract was signed, income is estimated as the present value of net future cash flow. What is astonishing is the Securities and Exchange Commission approved the accounting system, which had potential pitfalls, this method could augur well with securities but not for other businesses. For example: Enron would build an asset, such as a power plant, and immediately claim the projected profits in its books, even though it did not made any profit from it. If the revenue from the asset (power plant) was less than the projected amount, instead of accounting the loss and show it in their books, the company would make it an off – the – balance sheet transaction, where the loss would go unreported. By using this strategy the company could write off any losses while showing a healthy balance sheet.
Andrew Fastow, CFO a Wall Street recruit used another dubious strategy to make the company’s finances look great with false accounting, he started SPE (special purpose entities) where he could hide any assets which were losing money or business ventures that had gone haywire. To compensate the investors of this SPE, the company would issue common stock of the company to overcome the losses from their investments. Some reports suggest that the company created its own private hedge fund to assume some of the risk and absorb the losses, many insiders of the company were suspected of their involvement in this fraud. The summer of 2001 was the beginning of the end of the company, catapulted with a series of management resignations, the company changed its pension plan administrators, restricted employees to sell their stocks and closed one of its SPE, so that it need not distribute stock worth 58 million shares of stock, this action woke up the sleeping watchdog which ordered an inquiry into its SPE which was shutdown abruptly. This action by the SEC to investigate the SPE’s created by Fastow saw the company restating its earnings and showing losses of $ 591 million and a huge debt of $ 628 million by the end of 2001. The failure of the company was blamed due to its fraudulent accounting system and an audit failure, when its share prices plummeted to $ 1 in November 2001 after being $ 90.75 per share in the mid 2000’s its shareholders filed a $ 40 billion law suit against the company. The company once touted as America’s pride filed for Chapter 11 bankruptcy under the U.S. Bankruptcy Code on December 2nd, 2001.
Our View
Enron, diversified its business into the trading platform and used the dot com boom to record massive, unseen profits in Wall Street, but a lush for greed, wealth and quick money from the top management ruined the company. Investors, pensioners were subject to huge losses by the company’s creative accounting, reckless use of derivatives and special purpose entities. Its auditor Arthur Andersen one of the main culprits in the massive fraud remained a mute spectator, not only endorsing the accounting system but also siding with company’s management team, the auditor which found guilty by a U.S. Districts Court was later acquitted by the U.S. Supreme Court, by which the company had closed its operations.
http://www.internationalfinancemagazine.com/article/Enron-Americas-Greatest-Business-Debacles.html