Regulating the Financial System
Published 28 Feb 2017
Enron was created 1985 as a merger between Huston Natural Gas and InterWorth (BBC News, 2001). It was a company first credited with supposedly trading energy as a commodity like oil and memory chips. In August 14, 2001, Fortune magazine counted Enron as one of the top 10 stocks poised to grow for the next decade. According to BBC News, the company grew from naught to billions of dollars in just 15 years, a fact celebrated with numerous awards and approbation. At the end of 2000, Enron’s stock was trading at about $78, but by late November of the following year, the accounting scandal was unfolding and the stock was bid down to a mere $4.01 (Ackman, 2001).
Although many attribute the fall of Enron to have begun with investors pulling out money from company shares, the first suspicion was cast in the summer of 2000. According to Parry (2006), an employee of Southern California Edison wrote a memo to the Federal Energy Regulatory Commission noting that certain energy industry players, including Enron, were manipulating the distribution grid to cut off supply and artificially run energy prices up. California was in turmoil as rolling blackouts plagued the deregulated state. Washington turned a deaf ear and refused to alleviate an ailing market that saw energy prices increase 800 percent. The Bush administration defended its position by stating that price caps do nothing to the present levels of supply and demand, and would simply dampen investor interest. A price cap was eventually implemented but Enron had already managed to accumulate hundreds of millions in excess profit.
In that same summer, Enron unveiled a natural gas power plant in Dabhol, India. The power plant, however, presumably with a take or pay agreement with the Indian government, produced and sold electricity at a price many times over the norm. Enron demanded of the Indian government a $250 million payment for the electricity or to purchase Enron’s share in the plant amounting to $2.3 billion (Parry, 2006). When the Indian government refused payment, the Bush administration stepped in, pressuring India to make the payment through a series of meetings, negations and, finally, an official warning.
In August 15, 2001, Sherron Watkins, an Enron vice president, started reaching for the whistle, as she noted that Raptor, a subsidiary intended to hide losses, owed Enron about $700 million and had could not quite trace out the money (CNN, 2002). She warned other executives and attempted to clarify the accounting anomalies apparently racking the company, but could not secure a proper answer. By December of that year, Wallstreet was caught up bailing out; making the company’s stock worth virtually nothing, and forcing Enron to file for bankruptcy.
Coincident to the years leading to Enron’s Chapter 11, executive compensation was increasing at an exponential rate (Schifferes, 2003). In 1998, the total compensation package for Enron’s top 200 executives totaled only $193 million. In 1999 and 2000, the total compensation package made substantial increases to $401 million and $1.4 billion, respectively. According to Schifferes, a large chunk of the compensation package was in the form of stock options, wherein the beneficiary has the right to purchase the company’s stock at a fixed price. This provided incentive for the company to boost stock prices. The company’s executives’ methods included artificially jacking energy prices in California and pursuing over priced projects such as the Dabhol power plant, which respectively led to inflated revenue and asset figures. At the same time, subsidiaries such as Raptor were used to hide loss generating activities. The combined effects were inflated earnings reports, and fat payoffs to executives through exercised stock options.
The collapse of Enron brought about $60 billion in losses for the investing public (Thomas, 2002). The company also had more than 20,000 employees that lost their jobs, not to mention numerous pensioners, with substantially all of their working lives already spent, lost their only means of support. With the fall of Enron also came the fall of one of the largest accounting firms in the US – Arthur Andersen. The accounting firm served as auditor and consultant for the multi-billion dollar company and is largely held responsible for concealing Enron’s nefarious accounting practices. According to Cathy Thomas (2002), about a third of Andersen’s 2,300 clients quickly fled and turned to other firms for auditing services. The job loss was also apparent in the accounting firm as it sold portions of its business and reduced workforce numbers from 26,000 in the US to a mere 5,000.In the wake of Enron’s fall, the US capital markets turned cautious and indecisive. Pellegrini (2002) dubbed it the “Enron Effect.” His first case and point came on January 24, 2002 when Alan Greenspan had encouraging words that the worst is over, and strong performances from Nokia and Siebel put several market indexes much higher up during the morning session but cut any gain in half by the afternoon. He further reports that the first trading week of 2002, the Dow plunged some 20 percent as the Justice Department opened criminal investigations for the Enron Scandal.
One could argue that the timid stance of the Bush administration in placing a price cap on California’s energy price, and the administration’s aggressive stance with respect to the Dabhol project can be viewed as factors enabling Enron to pursue overstated earnings. However, the issue is muddled by viewing the administration’s stance as advancing capitalism and advocating nationalistic interests. What is clear is that legislation is needed to bridge the gap between the investing public’s information requirements and public companies that they entrust with hard earned money. The government quickly moved to pass the Sarbanes-Oxley Act of 2002 as a means of curbing unethical accounting practices.
A special feature in this piece of legislation is the inclusion of Section 401. Under this section, corporations subject to the act are required to report off-balance sheet transactions that can materially affect the company’s financial condition. These off-balance sheet transactions include guarantee contracts (e.g. take-or-pay), interests in assets transferred to subsidiaries, obligations brought about by derivative instruments such as forward agreements, and any material interest in unconsolidated subsidiaries and special purpose vehicles (SEC, 2003). Aside from additional reportorial requirements for subject companies, the act was also meant to have some teeth. Section 1102 places a stiff penalty for tampering with records or serving as an impediment to investigations. The Securities and Exchange Act of 1934 was further amended thru Section 1106 to have steeper criminal liabilities.
Some believe that the Sarbanes-Oxley Act has done its share to curb corrupt accounting practices. There have been major restatements over the years and companies have been more transparent as a result of the Act. However, Siegel, a member of the Center for Financial Research and Analysis, believes that companies are now focusing on non-accounting metrics (Bloomberg, 2005). While earnings can be manipulated, analysts find that cash flows and other non-accounting metrics can be less subject to management control. The trouble is, some companies can throw these non-accounting metrics toward analysts to justify or mask poor results. The question therefore remains as to whether passing the Sarbanes-Oxley Act has been effective as a safeguard for investors as corporate behavior remains the same.
- Ackman, D. (2001, November 27). Enron in free fall. Forbes.
- BBC News (2001, November 28). Rise and fall of an energy giant. BBC News.
- CNN Student News (2002, February 14). Enron’s Watkins warned Lay. CNN.
- Parry, R. (2006, May 26). Bush’s Enron lies. ConsortiumNews.com.
- Pellegrini, F (2002, January 24). The Enron effect. Time.