Wall Street Crime And Punishment: When Enron's Numbers Didn't Add Up

Does crime pay?

Wall Street Crime and Punishment is a weekly series by Benzinga's Phil Hall chronicling the bankers, brokers and financial ne’er-do-wells whose ambition and greed take them in the wrong direction.

Twenty years ago, Enron Corporation was considered to be among the most successful corporations. Indeed, 2001 marked the sixth consecutive year that Enron earned the title of “America’s Most Innovative Company” from Fortune magazine.

But as the year progressed, Enron’s appeal evaporated when its accounting practices were called into question and the company collapsed in one of the most dramatic corporate scandals in American history.

The Right Place And The Right Time: Enron was created in 1985 through the union of Houston Natural Gas, a gas exploration and production firm, and InterNorth, an Omaha-based pipeline network company.

InterNorth was the larger and richer of the two companies and it absorbed the Texas-based operation for $2.4 billion. Under the original acquisition agreement, the combined entity was to be known as HNG/InterNorth, with InterNorth CEO Sam Segnar at the corporate helm and the headquarters remaining in Omaha.

But one year after the transaction, Segnar abruptly retired and was succeeded by Kenneth Lay, the former Houston Natural Gas chief, who renamed the company Enron and shifted its headquarters to Houston.

When Lay took control, the company boasted the second-largest pipeline network in the nation with more than 36,000 miles of pipe. But Enron faced two major challenges: the federal government deregulated natural gas sales, thus requiring a new corporate operational strategy, and the combination of the two companies into Enron resulted in a debt load that was not easily shaken away.

The solution to Enron’s woes came via Jeffrey Skilling, a consultant with McKinsey & Co. Skilling devised an energy derivative concept called a “gas bank” that involved Enron purchasing gas from a network of suppliers and then selling it to a network of consumers. Under this strategy, Enron could charge fees for the transaction while guaranteeing supply and prices while managing risks. Skilling’s strategy worked so effectively that by the early 1990s the company became the largest seller of natural gas in North America.

The company began to divest its pipeline assets and expand beyond natural gas by bringing its “gas bank” model into different markets including coal, electric power, paper and pulp, steel and water. It also began to concentrate on a new market: broadband fiber optic, a crucial element in the decade’s fast-growing Internet environment. Lay recruited Skilling to lead a new division called Enron Finance Corp. that would coordinate the company’s diversification and paths into new corporate territories.

Unfortunately, the genius Skilling displayed in helping Enron find its feet proved to be the corporate equivalent of lightning in a bottle.

Kicking The Decimal Point Around: Skilling opted to shift Enron away from traditional accounting practices in favor of the mark-to-market method (MTM), and in 1992 the company received the blessing from the U.S. Securities and Exchange Commission to make the switch.

Whereas traditional accounting tabulates and record actual values, MTM determines a company’s value and worth using fair value appraising. Under the MTM system, profits can be listed as projected sums rather than actual numbers.

The drawback to the MTM approach is that it could be used to push an optimistic projection rather than consider an actual situation. Because of this consideration, MTM was not used outside of the financial services world until Enron became the first non-financial company to adopt this practice for its bookkeeping.

At the same time, Skilling worked with a young protégé named Andrew Fastow to handle a constellation of special purpose entities (SPEs) to handle the more complex aspects of Enron’s widening operations. SPEs are shell companies that function as limited partnerships or companies designed exclusively to either fund or manage the risks that are associated with specific assets.

By 2001, Enron was working with thousands of SPEs, many of which fully assumed the burden of the company’s unsuccessful ventures, enabling Skilling and Fastow to keep the poor performance aspect of Enron’s enterprises out of the earnings reports that were already being inflated thanks to MTM accounting. As a result, the company kept turning out quarterly reports bearing little resemblance to reality.

In August 2020, Enron’s stock hit a peak at $90.56. Lay retired in February 2001 and Skilling took over as president and CEO while Fastow functioned as chief financial officer. Skilling bragged that the company’s stock was on its way to reaching $126 per share. However, within 10 months the stock was trading at 26 cents per share — the too-confident Enron team was caught off-guard as something of an olfactory-offending nature unexpectedly hit the fan.

See Also: Previous articles in the Wall Street Crime and Punishment series.

Prelude To A Crash: Enron’s downfall can be traced to a September 2000 article in the Wall Street Journal about the use of MTM accounting in the energy industry. The article only appeared in the Texas regional edition of the newspaper, but it was seen by Jim Chanos, an investment manager with a penchant for short selling. Chanos’ curiosity was piqued by the article and he began to deep-dive into Enron’s numbers.

What Chanos found perplexed him: Enron was reporting profits in its broadband operations that bore no resemblance to the state of the sector. He also tracked high quantities of stock being sold by company insiders. Chanos began to short Enron stock and he convinced Fortune reporter Bethany McLean to take a closer look at the company that her magazine repeatedly hailed for innovative leadership.

McLean’s March 2001 article “Is Enron Overpriced?” was the first open assault against the too-rosy picture that the company’s leadership team was presenting to the investor community. Some financial analysts began to ask the company questions based on McLean’s writing. Skilling went on the defensive by crudely insulting anyone who questioned how the company operated, but offensive verbiage was not enough to shield the company from growing scrutiny.

Enron reported $4.8 billion in operating cash flow for 2000 — but beyond the imaginative bookkeeping, there was precious little cash flow to be found. Also in 2000, Enron reported $100 billion in revenue, but this came from trades for cash exchanges which did not occur. Meanwhile, the SPEs circling the company were hemorrhaging money on behalf of Skilling’s executive team.

Enron’s bookkeeping did not happen in secret. The company employed the Big Five accounting firm Arthur Andersen LLP to verify the numbers. Arthur Andersen never questioned Enron’s statistics during the company’s boom years.

Reality Bites: On Aug. 14, 2001, Skilling abruptly resigned from his leadership duties, claiming “personal reasons.” Lay was brought back to guide Enron, but the damage was already done.

On Oct. 16, 2001, the company published its third-quarter earnings report that finally reflected the truth: a loss based on charges totaling $1 billion from dismal business endeavors.

One month later, Enron published a restatement of its financial statements going back to 1997 that resulted in another $591 million in losses plus $628 million in liabilities. By this point, Enron stock was trading at less than $10 per share.

Enron filed for Chapter 11 bankruptcy on Dec. 2, 2001. In January, the company was hit with the one-two punch of a Department of Justice investigation and a delisting from the NYSE.

Enron tried to move much of the blame for its misfortune to Arthur Andersen by publicly firing the firm as its auditor on Jan. 17, 2002, claiming document destruction and inadequate guidance on accounting policy issues — although the accounting firm responded their relationship was already over when the Chapter 11 bankruptcy was filed one month earlier.

Enron’s accusation of document destruction was not a wild charge — one month before dismissing the accounting firm, Arthur Andersen acknowledged to several federal regulatory agencies that many paper and electronic records related to Enron had been destroyed.

Extinguishing Enron: If anything good came out of the debacle, it was the passage of the Sarbanes-Oxley Act in 2002, which updated federal policy on corporate accounting practices, thus preventing Enron Part 2 from ever happening.

Among the Enron executives who orchestrated this mayhem, Fastow pleaded guilty to two charges of conspiracy and was sentenced to 10 years in prison. While that might seem rough, it should be noted that sentence was actually the result of a plea bargain to testify against his colleagues. Fastow’s wife Lea, who held no position with Enron, was sentenced to one year in prison on a misdemeanor tax charge of helping her husband hide his income from the federal government.

Skilling was convicted of 19 of 28 counts of securities fraud and wire fraud and was sentenced to 24 years and four months in prison. His attorneys reached a deal with the Department of Justice in 2013 that resulted in 10 years being cut from his sentence.

Lay was convicted of six counts of securities and wire fraud and faced a maximum total sentence of 45 years in prison, but he died on July 5, 2006, prior to his sentencing. Sixteen other Enron executives would be found guilty of crimes committed on behalf of their employer, while 4,500 who worked for Enron found themselves out of work.

Arthur Andersen was found guilty of obstruction of justice for its destruction of Enron-related documents. This put the company out of business and 85,000 employees lost their jobs. The U.S. Supreme Court would later reverse the conviction on a technicality, but the firm was never able to return to operations.

The most tragic element of this story was the fate of J. Clifford Baxter, Enron’s chief strategy officer. Baxter was not part of the mayhem that crashed the company — in fact, he resigned after challenging his superiors on their wacky accounting practices and faced no criminal charges. But Baxter was named in a shareholder lawsuit and was called to appear before a U.S. Congress probe of the company’s collapse.

The shame of being in the national spotlight for crimes he did not create overwhelmed him, and he committed suicide from a self-inflicted gunshot wound before he was scheduled to testify. Baxter’s suicide note to his wife resonated with sincerity and humanity that none of the actors in this sorry drama could ever muster when confronted by their misdeeds.

In his final thoughts before removing himself from the human experience, Baxter wrote, “I am so sorry for this. I feel I just can't go on. I have always tried to do the right thing but where there was once great pride now it's gone. I love you and the children so much. I just can't be any good to you or myself. The pain is overwhelming. Please try to forgive me.”

Photo: courtesy of the Federal Bureau of Investigation.