ENRON FRAUD CASE SUMMARY Enron was formed in 1985, following a merger between Houston Natural Gas Co. and Omaha- based InterNorth Inc. Following the merger, Kenneth Lay, who had been the chief executive officer (CEO) of Houston Natural Gas, became Enron's CEO and chairman and quickly rebranded Enron into an energy trader and supplier. Deregulation of the energy markets allowed companies to place bets on future prices, and Enron was poised to take advantage. In 1990, Lay created the Enron Finance Corp. To head it, he appointed Jeffrey Skilling, whose work as a McKinsey consultant had impressed Lay. Skilling was at the time one of the youngest partners at McKinsey. Skilling joined Enron at an auspicious time. One of Skilling's early contributions was to move Enron from a traditional historical cost accounting method to a mark to market (MTM) accounting method, for which the company got official SEC approval in 1992. MTM is a measure of the fair value of accounts that can change over time, such as assets and liabilities. MTM aims to provide a realistic appraisal of an institution's or company's current financial situation. It is a legitimate and widely-used practice. However, it can be manipulated, since MTM is not based on "actual" cost but on "fair value," which is harder to pin down. Some believe MTM was the beginning of the end for Enron, as it essentially started logging estimated profits as actual ones. By the fall of 2000, Enron was starting to crumble under its own weight. CEO Jeffrey Skilling had a way of hiding the financial losses of the trading business and other operations of the company it was called MTM accounting. This is a technique used where you measure the value of a security based on its current market value, instead of its book value. This can work well when trading securities, but it can be disastrous for actual businesses. In Enron's case, the company would build an asset, such as a power plant, and immediately claim the projected profit on its books, even though it hadn't made one dime from it. If the revenue from the power plant was less than the projected amount, instead of taking the loss, the company would then transfer the asset to an off-the-books corporation, where the loss would go unreported. This type of accounting enabled Enron to write off unprofitable activities without hurting its bottom line. The MTM practice led to schemes that were designed to hide the losses and make the company appear to be more profitable than it really was. To cope with the mounting liabilities, Andrew Fastow, a rising star who was promoted to CFO in 1998, came up with a deliberate plan to make the company appear to be in sound financial shape, despite the fact that many of its subsidiaries were losing money. Fastow and others at Enron orchestrated a scheme to use off-balance-sheet special purpose vehicles (SPVs), also known as special purposes entities (SPEs) to hide its mountains of debt and toxic assets from investors and creditors. The primary aim of these SPVs was to hide accounting realities, rather than operating results. Enron would transfer some of its rapidly rising stock to the SPV in exchange for cash or a note. The SPV would subsequently use the stock to hedge an asset listed on Enron's balance sheet. In turn, Enron would guarantee the SPV's value to reduce apparent counterparty risk. Although their aim

was to hide accounting realities, the SPVs weren't illegal, as such. But they were different from standard debt securitization in several significant and potentially disastrous ways. One major difference was that the SPVs were capitalized entirely with Enron stock. This directly compromised the ability of the SPVs to hedge if Enron's share prices fell. Just as dangerous was the second significant difference, Enron's failure to disclose conflicts of interest. Enron disclosed the SPVs' existence to the investing public, although it's certainly likely that few people understood them, but it failed to adequately disclose the non-arm's length deals between the company and the SPVs. Enron believed that its stock price would keep appreciating, a belief similar to that embodied by Long-Term Capital Management, a large hedge fund, before its collapse in 1998. Eventually, Enron's stock declined. The values of the SPVs also fell, forcing Enron's guarantees to take effect. In addition to Andrew Fastow, a major player in the Enron scandal was Enron's accounting firm Arthur Andersen LLP and partner David B. Duncan, who oversaw Enron's accounts. As one of the five largest accounting firms in the United States at the time, Andersen had a reputation for high standards and quality risk management. However, despite Enron's poor accounting practices, Arthur Andersen offered its stamp of approval, signing off on the corporate reports for years, which was enough for investors and regulators alike. This game couldn't go on forever, however, and by April 2001, many analysts started to question Enron's earnings and their transparency. Arthur Andersen was one of the first casualties of Enron's prolific demise. In June 2002, the firm was found guilty of obstructing justice for shredding Enron's financial documents to conceal them from the SEC. The conviction was overturned later, on appeal, however, the firm was deeply disgraced by the scandal, and dwindled into a holding company. A group of former partners bought the name in 2014, creating a firm named Andersen Global. Several of Enron's execs were charged with a slew of charges, including conspiracy, insider trading, and securities fraud. Enron's founder and former CEO Kenneth Lay was convicted of six counts of fraud and conspiracy and four counts of bank fraud. Prior to sentencing, though, he died of a heart attack in Colorado. Enron's former star CFO Andrew Fastow plead guilty to two counts of wire fraud and securities fraud for facilitating Enron's corrupt business practices. He ultimately cut a deal for cooperating with federal authorities and served a four-year sentence, which ended in 2011. Ultimately, though, former Enron CEO Jeffrey Skilling received the harshest sentence of anyone involved in the Enron scandal. In 2006, Skilling was convicted of conspiracy, fraud, and insider trading. QUESTIONS: 1. What is the main problem of Enron? 2. What are the ethical issues on the Enron Scandal? 3. How did Enron hide their losses? 4. How can the Enron scandal be avoided?