research paper
COMPANY: Enron
INDUSTRY: Energy
SITUATION
In 2002, Fortune magazine still ranked Enron as the fifth-largest company in the United States, although by the time the magazine was published, Enron had already filed for Chapter 11 bankruptcy protection.12 It was quite a ride: from a
. regional gas pipeline trader to the largest energy trader in the world, and then back down the hill into bankruptcy and disgrace. Since some of Enron's former exec-
utives were still involved in litigation as this book went to press, some of the details were not known. We do know that the company, with the help of its invest-
ment bankers, accountants, and others, constructed a series of off-the-books part- nerships that were used to hide Enron's massive debt and inflate its stock price. These partnerships were managed by Enron executives-a clear conflict of inter-
est-who stood to benefit financially from the deals. Enron also used very aggres- sive accounting practices to bolster the bottom line. A particularly sad aspect of this debacle was how much Enron employees lost in their 401(k) plans as the stock price plummeted. In the fall of 2000, Enron changed administrators for its
40 I (k) plan and, as is typical, the plan was "closed" while that transfer took place. When a plan is closed, no one can buy, sell, or trade in his or her 40 1(k) until the moratorium is over. Sadly, this moratorium began just as the stock really began to tank, and by the time Enron employees could once again make changes in their 40 I (k) elections, the stock price had dramatically decreased and the retirement savings of many average employees were wiped out.
HOW THE COMPANY HANDLED IT
Executives denied there was trouble for as long as they could, but the fall from grace was swift and dramatic. Top executives resigned in disgrace and one committed suicide. The company filed for Chapter 11 bankruptcy in Decem- ber 2001 and later sold its primary energy trading unit. 13
RESULTS
The results continue to evolve as this book goes to press. Andrew Fastow, . Enron's former CFO, settled civil and criminal lawsuits in 2004. The complaint
by the Securities and Exchange Commission charged that he "defrauded Enron's shareholders and enriched himself and others by, among other things, entering into undisclosed side deals, manufacturing earnings for Enron through sham transactions, and inflating the value of Enron's investments." Fastow agreed to serve a lO-year prison sentence, pay a fine of more than $23 million, cooperate with the government's ongoing investigation into Enron, and be permanently barred from acting as a director or officer in a public company.14 In addition, Lea Fastow, Andrew Fastow's wife and a former assistant treasurer of Enron, was sentenced to serve a year in prison for pleading guilty to charges relating to the Enron mess. IS In May 2006, former CEO Kenneth Lay and former president Jeffrey Skilling were convicted of mutiple counts of fraud and conspiracy and will be sentenced in September 2006 (after this book goes to press). Matthew Kopper, a former managing director, pleaded guilty to money laundering and conspiracy to commit wire fraud, and he forfeited $8 million to settle an SEC civil fraud case. The accounting firm, Arthur Andersen, was convicted in a fed- eral court of obstruction of justice and relinquished its license to practice public accountancy. 16
Finally, the fines paid by various other players in the Enron collapse are startling. Enron itself paid over $2 billion in fines, including $1.5 billion for manipulating energy markets in California. And financial services corpora- tions paid huge sums to settle investor lawsuits connected to Enron: Citigroup paid $2.4 billion; JP Morgan Chase paid $2.2 billion; and other banks paid fines in the hundreds of millions to settle similar suits. 17
j COMMENTS
Once again, former SEC chairman Levitt aptly described the scope of the problems at Enron:
I think the Enron story was a story, not just of the failure of the firm but also the traditional gatekeepers: the board, the audit
committee, the lawyers, the investment bankers, the rating agen- cies. All of them had a part in this.
Take the rating agencies, for instance. They deferred down-
grading Enron, pending a merger which they knew very well might never have taken place.
Take the investment bankers, who developed the elaborate
scheme that Enron used to hide the obligations of the parent
company in subsidiaries. That didn't come out of the blue; that was a scheme concocted between the investment bankers and the chief financial officer of Enron.
Take the accounting firm .... Enron was the most important audit client that they had, and Enron was also the largest consult- ing client that they had-a client that paid them over a million dollars a week in fees. In my judgment, that accounting firm was compromised. Their audit was compromised. Putting aside any fraudulent activity that may have been part of this, they were clearly compromised by the nexus of consulting with auditing.
Take the lawyers that were paid vast fees. I think here you have a very interesting case where the American Bar Association
prevents lawyers from revealing financial fraud of clients to reg- ulators. And here we had a case in point where a major client of the law firm was obviously involved in practices that may well prove to have been fraudulent, and they didn't blow the whistle.
And [take] the analysts, who were claiming that Enron was
a buy even after this story had broken and Enron had declared bankruptcy. These are analysts that were being paid by invest- ment bankers that were receiving large fees from Enron for per- forming a variety of services. How independent could their research have been? And what could an investor have expected from an analyst who was recommending the purchase of Enron, while at the same time his employer was receiving millions of dollars in fees from that company? How likely was it that the analysts would tell it as it was? Very unlikely, in my judgment. 18
It appears that Enron had plenty of help in constructing its massive fraud. Its true financial performance was shrouded in partnerships that hid debt from its books and, as a result, from investors and from rank-and-file employees.
Enron was not alone, however, in its involvement in corporate conflicts of inter- est. The investment banking community has also been embroiled in myriad conflicts in recent years. In fact, investment banking firms-by their very nature-face a huge potential conflict of interest. They are in the business of helping corporations raise money in the markets and are consequently focused on keeping a client company's stock price as high as possible. Yet these same investment banks also serve investors, who are interested in buying stocks at as Iowa price as they can.19 Talk about tension! And that tension spilled over for several big firms in the late 1990s and early 2000s. Merrill Lynch was fined $100 million when its analysts-in e-mails to one another- pIivately trashed the stocks of the companies they were publicly touting to investors.2o That case and others like it were later parodied in a television commercial by invest- ment firm Charles Schwab & Co. In the commercial, a Wall Street manager is seen urging his brokers to push an unfavorable stock. He tells them, "Let's put some lip- stick on this pig." (Schwab does not underwrite stocks and consequently does not face
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the same conflict that other brokerage firms do.) James P. Gorman, a Merrill Lynch executive, called Schwab's commercial a "cheap shot" for "kicking someone when they're down."21 We wonder whether investors thought Schwab's commercial was a cheap shot or a pretty accurate portrayal of some Wall Street bankers.
Investment bankers were investigated for another major conflict-how much they knew about the alleged frauds committed at Emon, WorldCom, Adelphia, and other companies. At Enron, for example, banks such as Credit Suisse First Boston, Citi-
group, and JP Morgan Chase helped Emon structure the secret partnerships that hid Emon's debt and kept Enron's stock price high. Then these investment banks not only received fees for helping to structure debt, they also made money from their invest- ments in Emon stock.22 And as we've seen, those firms paid enormous fines for assist- ing Emon with its shenanigans.
But perhaps no conflict in investment banking is as egregious as what happened in a series of initial public offerings (!POs) for dot. com companies before the bottom of that market fell out in late 2000. According to some observers, many dot.com IPOs
in the late 1990s were nothing less than high-stakes poker games-with stacked decks-in which the young companies going public eventually got shafted and the investment bankers and their cronies made out like bandits. Traditionally, the objec- tive of an !PO is to raise money for fledgling companies-money that is used to grow the business, for marketing, to expand into new markets, and to invest in new technol- ogy. In the late 1990s and into 2000, investment banks began to aggressively under- price the stock in IPOs-instead of selling the shares to the investors who would pay the most for them, they handed them out to favored cronies or clients (in an effort to
gain favor) at a much reduced price. These cronies and clients-generally large, insti- tutional investors-would flip the shares when the stock reached its full market price on the first day of trading. The money that should have gone to the issuers went to the clients of the investment banks. Things got so bad that in 19-99and 2000, investment banking fees and forgone proceeds accounted for 57 cents of every dollar raised for IPO corporations.23 Those dot.com companies might have done better by going to mob loan sharks.