The Social Impact of Business Failure: Enron

Introduction
Enron, once the worlds largest energy company, was ranked number seven by Fortune magazine in April 2001 in Fortunes ranking by market capitalization of the five hundred largest corporations in the United States. On December 2, 2001, Enron filed for Chapter 11 bankruptcy. The sudden and swift collapse in the market value of this corporate giant has had major ramifications for nearly all of its stakeholders including, but not limited to, its shareholders, employees, creditors, and auditors. The causes and consequences of the Enron bankruptcy filing highlights the social impact of business failure, which is the focus of this paper. Before the collapse of Enron, many individuals and institutions in the United States, including representatives in the US Congress, were largely in favor of deregulation of business. However, in the wake of huge losses at the Enron Corporation, the debate on regulation vs. deregulation has been revived and gained momentum. It has become increasingly evident that corporate failure of the magnitude of Enron causes serious economic, political, and social dislocation. Before the securities market crash of 1929 and the Great Depression, there was very little support for governmental regulation of securities markets. Many individuals and institutions lost significant sums of money in the 1929 crash, which also brought about a steep decline in public confidence in securities markets. To restore the investing publics faith in capital markets, Congress passed the Securities Act of 1933 and Securities Exchange Act of 1934. These laws were designed to restore investor confidence in U.S. capital markets by providing for more structure and oversight. The Securities Exchange Act of 1934 created the US Securities and Exchange Commission (SEC). The primary mission of the US Securities and Exchange Commission is to protect investors and maintain the integrity of securities markets. The SEC oversees corporate disclosure of information to the investing

public. Public companies in the United States with more than $10 million in assets and whose securities are held by more than 500 owners are required to file annual and quarterly statements (Forms 10K and 10Q) with the SEC. These forms are supposed to disclose information about such public companies financial condition and business practices. This disclosure is expected to help investors make informed investment decisions. This SEC review process is intended to check if firms are meeting their disclosure requirements. The SEC seeks to improve the quality of the information disclosed and to help make a companys financial statements transparent, i.e., more easily understood by the investing public. The rest of this paper is organized in five sections. The first section discusses the roles and responsibilities involved in the financial reporting process. The second section covers a brief history of Enron, including a summary of events leading up to its bankruptcy filing. The third section discusses the social impact of this corporate failure. The fourth section discusses how and why the US corporate governance system failed to prevent this corporate collapse. It examines the role played by various agencies including Enrons consultants, its top management, its board of directors, external auditors, Wall Street analysts, and the government (SEC). The final section concludes the paper with a discussion of reforms following the Enron failure.

Roles and Responsibilities

The United States securities laws and corporate governance system requires that a board of directors supervise the management of each public corporation. Every director is expected to act in good faith and in the best interests of the company. The director, in exercising his or her duties, is expected to exercise skill and diligence. A director may be sued for the failure to take reasonable care, or for a breach of duty of care to the firm, in circumstances where it can be shown that he or she failed to exercise due care. If it can be shown that a director was knowingly a party to conducting the firms business in a reckless manner, the Courts may make the director personally liable for any harm caused to the firm. The role of the audit committee of the board of directors is delineated in the charter of the audit committee. Generally, the audit committee of the board of directors is responsible for recommending the selection of the companys external auditors and for recommending the fees payable to external auditors. The audit committee is also generally expected to review the audit plan

developed by management and the external auditors, and to periodically review the performance of the external auditors. The audit committee is required to review the firms annual financial statements, including whether the firms accounting and management systems and reports comply with generally accepted accounting principles (GAAP). The audit committee is expected to periodically review the firms system of internal controls includ-ing its risk management policy. The SEC views the firms audit committee as playing a critical role in the financial reporting system and requires extensive disclosures about a public companys audit committee and its interaction with the companys external auditors. The SEC requires audit committees to state whether they have reviewed and discussed the audited financial statements with the firms management and the independent external auditors. When a public company files its annual and quarterly reports with the SEC, the firms management is required to take responsibility for the integrity and objectivity of the firms financial statements. Management is expected to prepare the companys financial statements in conformity with GAAP. Management is also expected to have in place a system of internal controls designed to provide reasonable assurance of the reliability of financial statements as well as the protection of the firms assets from unauthorized acquisition, use, or disposition. The internal control system is to be strengthened by having written policies and guidelines that are to be implemented by qualified personnel who are carefully selected and trained for the task. The public firms financial statements are to be reviewed by independent external auditors. The firms external auditors have a duty to be objective in their review of the firms financial statements. While it is the responsibility of the firms management to prepare the financial reports, it is the responsibility of the firms external auditors to express an opinion on these financial statements based on their independent audit. The auditors are expected to perform the audit to obtain reasonable assurance that the financial statements are free from material misstatement. The auditors are required to opine if the financial statements prepared by management fairly present, in all material respects, the financial position of the firm and its subsidiaries on a given date. It is the responsibility of Wall Street analysts to provide an honest and unbiased evaluation of a firms performance and prospects when they issue buy, sell, or hold recommendations on the stock of a firm.

Despite all the checks and balances provided for in the U.S. corporate governance system as discussed above, Enron collapsed under the burden of its accounting scandals, just as its accountant Sherron Watkins warned in internal memos to the CEO Kenneth Lay and its external auditors, in August 2002 (Hamburger and Brown 2002). The Enron case exemplifies the great harm an accounting scandal and a large corporate bankruptcy can wreak upon society and its members.

Enron History
In July of 1985, Houston Natural Gas Inc. merged with Inter North Inc., a natural gas company based in Omaha, Nebraska, to form Enron an interstate and intrastate natural gas pipeline company. In 1989, Enron began trading natural gas commodities. In just a few years, Enron became the largest natural gas merchant in North America and the United Kingdom. Guided by the strategic advice provided by world-renowned business consultants McKinsey and Company (McKinsey), and the leadership of its former CEO, Jeffrey Skilling (a former employee of McKinsey), Enron transformed itself from an energy company to a risk management firm that traded everything from commodities to derivatives. Enrons consultants may have advised Enron to pursue a strategy of building a large firm with very few real assets on its balance sheet. The use of special purpose entities (SPEs) allowed Enron to operate extensive undercover and risky trading operations in a manner that did not properly reflect their debt on its balance sheets. The asset-light strategy, the SPEs, and the off-balance-sheet financing they provided to Enron appear to be the root cause of Enrons eventual failure. GAAP requires a firm to consolidate the financial statements of an SPE with the firms own financial statements unless the following two conditions are met: a. The SPE has to have an independent owner with a minimum of 3 percent equity capital at risk throughout the transaction. b. The independent owner has to exercise control of the SPE (Hancock and Britt 2002). Enrons external auditors Andersen LLP (Andersen) approved Enrons use of SPEs. However, some of Enrons SPEs did not meet GAAP non-consolidation rules. Enrons use of SPEs and the manner in which Enron accounted for them

made Enrons financial statements very complex and difficult to understand. The SPEs also provided rich rewards to some of its officers, including the firms former Chief Financial Officer (CFO), Andrew Fastow. Andersen performed both the external and the internal audits for Enron and also served Enron as a consultant in non-audit and tax matters. Andersens three-way relationship with Enron created the possibility for several conflicts of interest. On the political front, Enron, its chairman Kenneth Lay, and its auditors contributed generously to the campaigns of many politicians in both major political parties in the United States (Watts 2001; Adamson 2002; Spain 2002a, b). Its political donations may have given Enron some political power and some influence over the formulation of a U.S. energy policy favorable to the company. Despite its strong political connections and high visibility, the hazardous nature of its capital structure strategy and its risk management business essentially made Enron a firm built on very weak financial foundations. The first sign of weakness in the firms financial structure became obvious on October 16, 2001 when the firm reported a $638 million third-quarter loss and disclosed a $1.2 billion reduction in shareholder equity, partly related to SPEs run by CFO Andrew Fastow. This disclosure brought closer attention to the manner in which Enron was financing its operations. Thereafter, a quick downward spiral in the stock price of the firm ensued as additional disclosures followed. On October 22, 2001, Enron acknowledged that the SEC was inquiring into a possible conflict of interest related to the companys dealings with its SPEs. On November 8, 2001, Enron filed documents with the SEC revising its financial statements for the past five years to account for $586 million in losses. Faced with the possibility of a downgrade in its credit rating and a consequent cash shortage, Enrons management attempted to sell Enron to energy rival, Dynegy, who initially agreed to buy Enron for over $8 billion in stock. However, Dynegy backed out of the merger agreement on November 28, 2001 shortly after independent credit agencies downgraded Enrons debt to junk status to reflect Enrons rapidly deteriorating financial condition. This led to the final collapse in the price of Enron stock that thereafter traded below one dollar per share after trading as high as $90 per share. Enron was forced to seek protection under Chapter 11 of theUS Bankruptcy code on December 2, 2001. The firm was eventually delisted from the prestigious New York Stock Exchange.

Social Impact of the Enron Bankruptcy

As the value of Enron stock plunged in value, many Enron employees lost their jobs and nearly all of their retirement savings. In their testimony before Congress, former Enron employees testified that while they had retired with $700,000 to $2 million in Enron stock, they now had virtually nothing except their social security funds. To make matters worse, many of these employees were restricted from selling their stock even as the stock price declined in value, while senior officers of the firm were able to sell their Enron stock without similar restrictions (Schultz 2002). The issues of restricting stock sales and the percentage of stock held in individual 401(K) plans are some of the many troubling issues to emerge from the Enron crisis. The steep financial losses and loss of jobs is not limited to the employees of Enron. Over 28,000 employees at Andersens U.S. operations, many of whom were completely uninvolved with the Enron audit, are at risk of losing their jobs and thousands of Andersen employees have already been laid off. Around 1,750 Andersen partners may lose most of their entire life savings as the ongoing financial viability of the auditing firm is in jeopardy (Dugan and Spurgeon 2002; Bryan-Low 2002). Following the release of the Powers Report, it appears the Justice department focused immediate and greater attention on the role of Andersen in this corporate accounting scandal. In March 2002, the Justice department indicted Andersen, the entire auditing firm, not just individual auditors at Andersen, for obstruction of justice when they shred documents relating to the Enron audit. It is noteworthy that similar indictments have not yet been issued for the top managers at Enron. Following this indictment of Andersen, the trickle of corporate clients dropping Andersen as their external auditor of choice became a flood. By April 8, 2002, Andersen had lost around 150 U.S. public clients, which will have an immediate and severe negative impact on its revenues. Andersens chances of winning a favorable settlement with the Justice Department was greatly reduced when David Duncan, the lead Andersen partner involved in the Enron audit, pled guilty on April 9, 2002 to criminal obstruction of justice charges due to his involvement in Enron-related document shredding. On April 19, 2002, Andersen broke off settlement talks with the Justice Department. The case is expected to go to trial in Houston, Texas, on May 6, 2002. If Andersen is convicted of obstruction of justice, it would be extremely difficult for the firm to survive because the firm would be

unable to continue to audit publicly owned firms without obtaining a waiver from theSEC. Even without a criminal conviction, following the example set by the Arizona state board, several other state accounting boards may revoke Andersens licenses, without which Andersen will be unable to practice in such states. Following the Justice Departments indictment of Andersen, several additional lawsuits have been filed against Andersen by shareholders of Enron who seek to hold Andersen accountable for Enrons audits. The financial losses due to loss of business with the departure of clients, the potential liability from an SEC investigation and the Justice Departments indictment and numerous lawsuits raise the odds that the Enron bankruptcy will bring about the bankruptcy of its external auditor. This will clearly hurt many Enron and Andersen stakeholders, including those not directly involved with the accounting scandal. The sharp and sudden decline in the value of Enron stock adversely affected the retirement savings of thousands of ordinary Americans who had no direct connection with the firm. Many Americans invest their retirement savings in mutual funds and especially in index funds because of their relative safety and reliable performance. Enron was a member of the Standard and Poors (S&P) 500 Index until November 29, 2001. All Index funds seek to replicate the performance of their Index. Therefore, over twenty-five mutual funds listed in the S&P 500 Index had to include Enron stock in their investment portfolios until Enron was removed from the S&P 500 Index. Because Enron was dropped so late from the S&P 500 Index, many individual investors who invested in index-funds lost money because by the time Enron was dropped from the S&P 500 Index, the stock had lost over 99 percent of its market value. To the extent index funds reduced their holdings of Enron as the market value of the firm fell, they would have been able to cut their losses. However, they could not completely eliminate their exposure to Enron as long as Enron was in the Index. There were also many other actively managed portfolios, including those of many university foundations (such as the investment portfolio of the University of California), which had substantial exposure to Enron. Portfolio managers of some of these investment funds did not in fact reduce their exposure to Enron as its stock price fell. Some asset management companies even used the price decline as an opportunity to add to their positions. For example, Alliance Capital Management (Alliance), the investment manager for the Florida Retirement System (FRS), bought 4.9 million shares of Enron for FRS between August and November 2001. Two days before Enron filed for bankruptcy, Alliance sold 7.5 million shares of Enron. Alliance was the asset

management firm with the largest exposure to Enron (see Table 2). Estimates of losses in FRS portfolio holdings of Enron range from $281 million to $321 million. FRS fired Alliance in December 2001. The American Federation of State, County and Municipal Employees, one of the largest public employee unions in the US, is currently investigating why the Florida State Board permitted Alliance to continue buying Enron shares even after the SEC investigation into Enron was announced in October 2001. Mutual funds are only required to release complete lists of their holdings twice a year. Therefore, it is difficult to precisely identify how many other actively managed funds also held Enron stock in their portfolios. It is known that many reputable mutual fund companies including Janus, Alliance, Putnam, Aim, Fidelity, and Vanguard families of mutual funds held substantial amounts of Enron stock (See Table 1 and Table 2, and Wiser 2001). Enron stock formed part of the investment portfolios of several state pension plans, university and other non-profit foundations. As of June 20, 2001, the Teachers Retirement System of Texas owned 2.2 million shares and CALPERSheld 3 million shares (Wiser 2001.) Portfolio managers of the funds that held Enron had a fiduciary responsibility to make safe and knowledgeable investments. In order to accomplish this, portfolio managers had an additional responsibility to adequately scrutinize all documents a firm files with the SEC before they invest in the firm. Although financial statements provided by Enron were allegedly lacking in financial transparency, a prudent financial manager should have refrained from investing in any firm whose financial statements he/she did not fully comprehend. Portfolio managers failed in their fiduciary responsibility to keep individual investors funds safe when they invested in Enron if they did not properly understand how the firm made the profits it reported. The social impact of this failure in fiduciary responsibility is reflected in the millions of dollars lost in Enron stock investments by individual and institutional investors. Many of Enrons trading partners such as Citigroup and J.P. Morgan also suffered steep losses because of the Enron collapse and within days of the Enron bankruptcy filing provided the public and their stakeholders with preliminary estimates of their Enron exposure (See Table 3).

Causes and Consequences of Multiple Failures

The failure of Enron was a result of a combined failure on several fronts. It was a failure of the high-risk, assetlight business and financial strategy pursued by Enron presumably under the advisement of its business consultants, McKinsey and Company. The Wall Street Journal reports that McKinsey and Company, in an internal document, praised Enrons use of off balance sheet funds using institutional investment money [which] fostered its securitization skills and granted it access to capital at below the hurdle rates of major oil companies (Hwang 2002, B1). The consultants deny being involved in the review of decisions made about Enrons investments, yet McKinsey and Company served as advisors to Enrons board of directors in the year preceding Enrons bankruptcy filing and at least one senior partner from the consulting firm attended six board meetings at Enron from October 2000 to October 2001. At these board meetings, the former Enron CEO Jeffrey Skilling reportedly emphasized the need for SPEs to help bolster the firms growth (Hwang 2002). If Enrons balance sheet had contained a greater proportion of tangible and especially fixed assets with stable market values, the market value of the firm may not have collapsed as it did, and the fixed assets could have been sold to meet its financial obligations. There are many levels of blame in this corporate crisis. Enrons top managers are clearly responsible for poor business decisions and mismanagement of the corporation. Not surprisingly, when required to testify before the U.S. Congress on the reasons for Enrons collapse, most of Enrons managers sought refuge under the Fifth Amendment. Decisions that individuals and corporations make often have multiple, systemic effects. Often, individual decision makers underestimate the consequences that follow from their decisions. When the governing bodies of corporations do not understand, or take account of all future consequences, serious moral hazards result. Messick and Bazerman (1996) argue that potential consequences are often ignored because of five possible biases: ignoring low probability events, limiting the search for stakeholders, ignoring the possibility that the public will find out, discounting the future, and undervaluing collective outcomes. It now appears that Enron management and the Board maintained all of the five biases to some extent. The many decision makers involved with Enron would have better served all stakeholders if they had considered the full spectrum of consequences associated with their decisions (Messick and Bazerman 1996, p.3). The Board of Directors for any corporation is an important body in the provision of effective corporate governance and oversight of management.

Carroll (1979) lists the four responsibilities of the managers of a business organization in the order of priority as: economic, legal, ethical, and discretionary. Enrons directors and officers may have failed to adequately perform their task of protecting the investments of Enron shareholders in at least three (economic, ethical, and legal) of the four responsibilities outlined by Carroll (1979). Ethical behavior for corporations is outlined in a companys code of ethics, which specifies how an organization expects its employees to behave when on the job (Hunger and Wheelan 2000.) Enrons Board of Directors suspended the companys code of ethics twice in 1999 to permit the creation of two SPEs controlled by Enrons former CFO, Andrew Fastow, who stood to personally benefit from these arrangements. Enrons audit committee may have failed in its responsibilities as outlined in the introduction of this paper. The audit committee included educated, respected professionals such as a retired professor of accounting from Stanford University, the former head of the Commodity and Futures Trading Commission, and the director of regulatory studies at George Mason University. Hence Enron shareholders may have believed it extremely unlikely that the audit committee of Enron would fail in its core responsibility of providing oversight of the companys external auditors, reviewing the firms system of internal controls and risk management policy, and ensuring the compliance of the firms accounting and management systems and reports withGAAP. A possible explanation for this puzzle is contained in the Report of the Special Investigative Committee of the Enron Board of Directors (Powers, Troubh, and Winokur 2002). According to the Powers Report, some of the involvement of the Enron officers in some SPEs may not have been fully disclosed to either Enrons Chairman and CEO, Kenneth Lay, or to the Board of Directors. The Board approved the CFOs participation in the SPEs with full knowledge of the potential conflict of interest. However, the Enron Board believed that the conflict of interest and the risks associated with it could be monitored effectively by oversight provided by senior management and the Board. The Board believed that the benefits of the SPE transactions outweighed the potential risks and costs. In hindsight, it appears that the controls designed were not sufficiently rigorous and that management and board oversight was insufficient. According to the Powers Report, the Enron Board believed that the SPE transactions were genuine economic hedges when in reality they were merely accounting hedges that permitted Enron to manage its earnings. The Boards decision to permit the CFO to control some SPEs was unwise. The Board can justifiably be criticized for failing to request additional information

where the information presented by management was insufficient to make effective decisions. The Powers Report concluded that some board members did not fully understand the risks and consequences of theSPE transactions. Enron paid Andersen $5.7 million for advice on some SPE transactions (e.g. SPEs named LJM and Chewco). The Board and its audit committee apparently relied heavily on the advice provided to the Board and management by Andersen on SPE transactions. The Powers Report simply states that the Board of Directors of Enron failed in its oversight duties, mostly via inaction. Several insurance firms who underwrote liability coverage for Enrons directors and officers are reported to be considering the suspension of insurance policies on the grounds that Enron directors and officers may have misled insurers by renewing the insurance policies based on earnings reports that were subsequently restated (Lublin and Emshwiller 2002). Academic literature acknowledges the importance of actively managing a firms reputation. Customers, employees, and shareholders of businesses are increasingly intolerant of ethical lapses in business management. As a result, firms are required to be more closely focused on reputation management (Fry 1997). Giampetro-Meyer (1998) recognizes that even the most socially responsible businesses have serious ethical failures at times. Moreover, she rightly acknowledges that, as organizations increase in size and complexity, it is often difficult to carry out their missions in a consistent and responsible manner. She argues, For-profit, publicly-held companies are messy, filled with contradictions and inconsistent behavior (Giampetro-Meyer 1998, p.3). From all appearances, Enrons Board of Directors and officers did not adequately consider their companys reputations, or their own, in the decision-making process. As Enron grew from a mere natural gas pipeline company to become the largest natural gas merchant in the U.S., and later a global energy and risk management business, it seems that its management and Board found it difficult to carry out the mission of the firm in a consistent and responsible manner. Enrons collapse also might have been averted had there been a truly independent and objective review of its financial statements by its auditors. Securities laws in the U.S. require independent auditors to obtain reasonable assurance that the financial statements are free from material misstatement. Auditors are required to opine if the financial statements present in a fair manner, in all material respects, the financial position of the client firm. In his

testimony before Congress, the CEO of Andersen, Joseph Bernadino, admitted that his firm had made an error in judgment (Babington 2002,1). Andersen was far more than just an independent external auditor to Enron. Andersen functioned as the external auditor, the internal auditor, and as tax consultant to Enron. Andersen claimed to have pioneered a unique integrated audit system in its audit of Enron. In this integrated audit system, Andersen operated like a branch of Enron, maintaining offices within Enron headquarters. It now appears that the distance necessary between auditor and client did not exist. In addition, it appears the integrated audit system may have led to several conflicts of interest and possible legal and ethical violations. Andersen was involved in structuring some of the SPE transactions, which were not true economic hedges, but merely vehicles that permitted Enron to manage its earnings. As mentioned earlier, Andersen was paid $5.7 million for its advice on SPE transactions. In the year before Enrons bankruptcy filing, Andersen earned $25 million for its audit of Enron and $27 million for nonauditing work, including tax-related and consulting services. According to the Powers Report, Andersen apparently failed to note or take action with respect to the deficiencies in Enrons public disclosure statements,[and] failed to bring to the attention of Enrons Audit and Compliance Committee serious reservations Andersen partners voiced internally about the related party transactions (Powers, Troubh, and Winokur 2002, 25). On January 16, 2002, Andersen disclosed that some partners and employees in its Houston office had destroyed and deleted thousands of documents relating to the Enron audit. Immediately following that disclosure, Andersen fired four of its partners in its Houston office, including the lead partner handling the Enron audit, David Duncan. Andersen then began a public relations campaign to restore its tarnished image. On January 18, 2002 Enrons Board of Directors fired Andersen as its auditor. One of the more troubling aspects of the Enron failure is the shredding of audit related documents by Enron and Andersen shortly after they realized that Enron had several accounting irregularities. As Skupsky (1993) writes, it is a well-established fact that the legal responsibility for records management generally lies personally with those who are responsible for the entire organization officers and directors are unprotected by the corporate shield when willfully failing to meet their responsibilities (Skupsky 1993, 33). One consequence of the Enron case is the increased awareness of the boards responsibility and auditors responsibility to preserve all material, especially financial and audit-related documents. The document

shredding by some Andersen employees may well bring about the demise of Andersen as the Justice Department proceeds with its criminal indictment for obstruction of justice against Andersen. Enron could not have succeeded without the cooperation and support of its bankers and trading partners who helped finance its operations. Some Enron bankers (e.g., JP Morgan) helped finance Enrons elaborate strategy of tax avoidance. Consequently, Enron did not report a tax liability or pay any income taxes for several years (Sapsford and Raghavan 2002.) The trading and financing scheme Enron had with its banker and trading partner, J.P. Morgan, was initially financially rewarding to the banker, providing it with about $100 million a year in revenues while the bank believed it had insured any possible default by Enron (Sapsford and Raghavan 2002). However, subsequent to Enrons bankruptcy filing, several insurers filed lawsuits claiming the trading transactions were a sham thereby voiding the insurance contracts. Immediately following the Enron bankruptcy filing, J.P. Morgan estimated its Enron liability at about $900 million ($500 million of unsecured exposure and $400 million backed by pipeline assets). However, after insurers refused to honor their commitments J.P. Morgan increased its estimate of Enron exposure to $2.6 billion. It now seems clear that J.P. Morgans assistance in helping Enron practice tax avoidance, while not illegal, did not benefit the long run interests of Enron or J.P. Morgan. The stock research that Wall Street analysts publish and provide to their clients and/or to the public must be independent, fair, and unbiased. Analysts are not supposed to mislead investors with excessively optimistic corporate research especially when they publish stock research on their firms investment banking clients. The periodic representations Enron made to the SEC, via its 10-Q filings, were severely lacking in financial transparency (clarity). In March 2001, several months before the stock of Enron collapsed, a Fortune Magazine journalist raised a red flag about the notable lack of transparency in Enrons financial statements (McLean 2001). Credit analysts at Standard and Poors and Fitch have conceded that the numbers presented by Enron were extremely complicated and difficult to understand. Nevertheless, most of Wall Street was bullish on Enron stock. The positive rating given to Enron stock by Wall Street firms undoubtedly induced many investors (individual and institutional) to invest in the stock. Some Wall Street analysts remained bullish on Enron even as the value of the stock plunged precipitously and this may have influenced the decisions of investors.

The impact of a positive recommendation given by Wall Street should not be underestimated. Prior academic research in finance has shown that upgrades and downgrades by Wall Street clearly influences investor enthusiasm for individual stocks. It also has a significant impact on the market value of a firm (Glascock, Davidson, and Henderson 1987; Zaima and McCarthy 1988; Hand, Holthausen, and Leftwich 1992; Goh and Ederington 1993; Elayan, Maris, and Young 1996; Liu, Seyyed, and Smith 1999; Kliger and Sarig 2000). The positive recommendation given by Wall Street to Enron stock, although perhaps based on the imperfect information it received from the firm via its conference calls and SEC filings, contributed to inflating Enrons stock price. Furthermore, the delayed response by Wall Street in downgrading Enron stock accentuated the financial losses of some investors by persuading them to hold onto Enron stock for too long. Critics of Wall Street behavior are quick to point out that the potential for conflicts of interest exists with many large Wall Street firms. Wall Street firms typically earn large fees for the investment banking services they provide to companies, which may make them somewhat reluctant to provide any negative commentary on a firm that is also a client. To what extent this might have played a role in Wall Streets positive coverage of Enron is not fully known. However, Wall Street had a variety of relationships with Enron and its top management that created conflicts of interest. Wall Street firms served as lenders and underwriters to Enron in several Enron stock and bond deals; managed assets for the firm as well as for investors owning Enron equity and debt; provided Enron with merger and acquisition advice and did private banking business with Enron top management. The conflicts of interest resulting from this multiplicity of Wall Street relationships with Enron, may have contributed to Enrons failure. Given the serious ramifications of these types of conflicts of interest, this matter is currently under investigation by the House Committee on Government Reforms (Sapsford and Wilke 2002). In the context of the Enron investigation, Congress questioned the SEC Chairman Harvey Pitt, its former chief accountant, Lynn Turner, and former SEC Chairman Arthur Levitt. The SEC may have been overloaded with the job of reviewing the information provided by firms during the flood of initial public offerings that took place from 1998 to 2000. Due to this work overload, it is possible that accountants at the SEC failed to adequately review the filings made by Enron in a timely and detailed fashion. Had a rigorous detailed review been done earlier by the SEC, Enrons problems might have been detected sooner. The SEC commenced its investigation of Enron only after October 16, 2001, when the firm disclosed its earnings shortfall. The

delayed oversight activity by the SEC was obviously much too late to stem the tide of Enrons collapse.

Reforms Following the Enron Collapse

The collapse of Enron and the economic and emotional impact it continues to have on thousands of ordinary Americans, Enron and Andersen employees, and investors demonstrates the widespread impact a major business failure can have on society. The fact that the issue was found worthy of indirect mention by President Bush in his State of the Union address on January 29, 2002, is testimony to the magnitude and importance of this business failure on American society and the U.S. capital markets. Americans have learned many sad lessons from this debacle and it is expected that some legal and social reforms will follow. The reforms will most likely include legislation surrounding employees pension and benefit plans and enforcement of the oversight role played by a firms auditors and Board of Directors. Following the collapse of Enron, Senators Corzine and Boxer proposed a twenty percent limit for any one stock that can be invested in any single 401(K) plan. In addition, President Bush called for the creation of a task force to identify methods to strengthen Americans retirement security. This task force, composed of Commerce, Labor, and Treasury Department members, will closely examine the potential problems related to employers restrictions on portfolio diversification and employees sale of stock. They will also research whether employees get proper investment advice regarding their retirement plans and whether the government has adequate tools to protect workers pensions (Chen 2002). In addition to the federal governments proposals, many institutional investors, including the many mutual funds that lost money by holding Enron in their stock portfolios, are pressing firms to adopt conflict-of-interest policies that would prevent a firms auditors from doing non-audit work for their client. The Enron auditors maintain they do not believe their non-auditing fees compromised their auditor independence (Solomon 2002). A recent unpublished study by DeFond, Raghunandan, and Subramanyam (2002) also finds no significant association between the ratio of audit to non-audit fees paid and the likelihood of an auditor issuing a going concern opinion. However, the authors admit the study does not consider the broader range of issues raised by stakethe Enron case and does not examine whether highly paid auditors might

be influenced to allow companies to inflate or even misstate earnings (Gentile 2002, p.1). The fallout of the Enron crisis may be a period of greater regulation over a broad range of issues ranging from regulation of utilities to regulation of accounting standards. There is no doubt that this corporate collapse will increase the debate concerning the deregulation of public utilities and other related industries. Yetmar, Cooper, and Frank (1998) acknowledge that the auditing profession has inherent conflicts between the public interest and the interests of the client, which create the possibility for a variety of problems. Both Arthur Levitt (former chairperson of the SEC) and Lynn Turner (former SEC chief accountant) have called for reform of the SEC and the accounting profession (Schroeder 2002b). Levitt has suggested that the SEC needs to adopt new standards that better track the effect of executive stock options on a firms financial statements and to require full disclosure of off-balance-sheet transactions and SPEs like those that Enron used to hide its losses. The current SEC chairman, Harvey Pitt plans a series of reforms of the accounting industry including new forms of oversight and new rules for greater disclosure. (Schroeder 2002a). The SEC has been concerned about improving the standards for SPEs for over fifteen years. The Commission first asked the Financial Accounting Standards Board (FASB) to improve these standards in 1985. The FASB responded with a set of rules that allowed firms considerable flexibility in reporting these transactions. Because the rules in place are not stringent, Enron was able to manipulate its financial situation. In 2000, the SEC went back to the FASB asking for a set of stronger rules regarding the reporting on special purpose entities. The stronger rules did not come soon enough to prevent the Enron accounting scandal. On April 23, 2002, Enron reported it may write down the value of its assets by $14 billion due to possible accounting errors or irregularities in earlier financial statements prepared by Enron management and reviewed by Andersen (Pacelle 2002). The Enron debacle may have motivated the FASB to quickly create a stronger set of rules governing the disclosure of SPEs that may help prevent future accounting scandals. In August 2002, the FASB is expected to release the final draft of an Interpretation of Statement No. 941. The FASB is considering a new approach to accounting for SPEs. The new approach, if approved, will require consolidation of nonsubstantive entities by the primary beneficiaries of the SPEs activities.

The FASB is also considering changing the threshold for equity capital at risk from three percent to ten percent (Hancock and Britt 2002). The collapse of Enron stock, its financial restatements, and the subsequent disclosures made by its auditors have shaken the faith of the investing public in the entire accounting industry with particular concern for the role of auditors and the reliability of their financial disclosures (Andreczak 2001). The SEC chairman argues that the current system of corporate disclosure is outmoded and incomprehensible and driven by a system of disclosure to avoid liability rather than to inform investors (Schroeder 2002a). The SEC upholds there should be a series of accounting industry reforms, including new forms of oversight and new rules for expanded corporate disclosures (Schroeder 2002a). The SEC is also considering increased regulation of U.S. credit agencies because the rating agencies were very late in downgrading the stock of Enron (Schroeder 2002c). On April 24, 2002, the US House adopted HR 3763, a bill designed to boost investor confidence. The bill makes it a crime to lie to an auditor, creates a new independent board to oversee accountants, and grants wider oversight powers to the SEC. The bill also prohibits accounting firms from providing certain consulting services to companies whose books they audit; requires audit papers to be kept for seven years, and bars executives from trading in company stock during blackout periods in which employees were prohibited from selling the stock from their retirement savings accounts. The bill has yet to be approved by the Senate. The Enron case has focused public attention on the distance that must be necessarily maintained between business and government. Even the perception of government culpability in the Enron case has shaken the American publics faith in the impartiality of government. While it is clear that Enrons financial contributions to both parties did not win the firm its requested bailout from the White House in October 2001, it is possible that the firms management was able to influence government policy to its advantage in prior years. While no improprieties have been proved to date, the media has raised many questions about the relationship between Enron and the government (Wilke 2002). The Enron case has heightened public awareness of the need for distance between business and government while at the same time sparking debate about when regulation is necessary. The complete story of Enron is yet to be fully told and the case will likely be discussed and debated in courtrooms and classrooms of business schools for

many years to come. The story of Enron is replete with numerous instances of conflict of interest in the present system of corporate governance. The failure of Enron demonstrates the vital role business plays in American society and therefore underscores the importance of good governance in business. It also reinforces the multiplicity of stake-holders that any large corporation must consider in its decision making processes. Apart from the obvious social impact of financial losses created by the Enron collapse, the social impact of the crisis of confidence that this incident has created in capital markets is greatly troubling. As a result of the Enron collapse the public currently has less confidence in the management of large corporations, in the independence of auditors, in corporate accounting and reporting practices, in Wall Street analysts, in mutual fund and pension fund managers, in theSEC and in the government. This lack of confidence is reflected in our currently weak financial markets. Investor perception of reality and facts is as important as the facts themselves when investors make their assessments of firms. Investor perception of wrongdoing in the Enron case has had a depressing effect on the stock market and the U.S. economy even though no wrongdoing has yet been proven. The multiplier effect of this crisis in confidence cannot be taken lightly. Its result, among other things, is a more difficult environment for business and government. While the task of effectively managing a company the size and scope of Enron is daunting, there is an ethical obligation to make every effort to manage these firms by reviewing all the consequences of the decisions they make. There is the potential that some social good will eventually emerge from this business failure as government, business, and employees come together to reform the systemic flaws that the Enron crisis illuminated.

ENRON Failure: Who's to Blame?

At first glance, it would appear that ENRON's senior executives, notably Lay, Skilling and Fastow, are the primary suspects. However, they claim that they were operating with the consent and approval of the ENRON Board of Directors. The Auditing Committee of the Board of Directors continued to rely on its public auditing firm, Arthur Andersen, who continued to write favorable opinion letters that ENRON's accounting was "adequate to provide reasonable assurance as to the reliability of financial statements" for the years 1998, 1999 and 2000. Arthur Andersen public auditors were using the accounting system

that was developed by ENRON in conjunction with the advice and counsel of the consulting arm of Arthur Andersen. The accounting system was developed also to conform to Generally Accepted Accounting Principles (GAAP), as interpreted by joint agreement of Arthur Anderson auditors and the consulting unit, ENRON accounting personnel and, to some extent, by the legal firms passing favorable opinions on accounting and tax treatments of the ENRON related partnerships (SPE's). Throughout ENRON's history, up to the October-November, 2001, restatement of the income statement and balance sheet due to the LJM and Raptor partnerships, all of the players indicated above were giving each other confirmation and approval for the accounting and business practices that suddenly were being undone in October. In the previous year, ENRON paid over $50 million to Arthur Andersen for their consulting and auditing services. The law firms, providing services and opinions to ENRON, received about $50 million in fees. As a result, the various ENRON players were all confident that they were operating in a system where each was being covered by the actions and confirmations of others in the system. Nobody did anything wrong, because the actions were all blessed by the other players in the system! But who else was involved in ENRON debacle? Lets us not forget the various members of the financial community, i.e., the banks, credit rating agencies and the securities brokerage firms. Recent hearings in the U.S. Senate explored the activities of J.P. Morgan Chase and Citibank (the banking side of Citigroup) with ENRON. Apparently both of these banks were involved in what are called "prepay" energy transactions. Employees of the banks were dealing with ENRON and ENRON partnerships to provide cash to ENRON for its day-to-day financial operations, in ways that could be reported as "operating activities" versus "debt financing" activities. The banks were finding ways, supported by legal and accounting opinions, that enabled ENRON to engage in practices that had the effect of hiding its debt obligations off-the-balance sheet, while appearing to report positive profits and flow of funds from operations.

Merrill Lynch dealt with an ENRON partnership (the Nigerian Barge Project) in a transaction that allowed ENRON to report a $12 million addition to profits just before the end of fiscal year 1999. Merrill Lynch claimed that the transaction was a $7 million purchase of equity, with attendant equity risks, but even Merrill's own company newsletter and executive e-mails were indiscriminant in referring to the deal as "equity" in some documents, and a "loan" in other documents. In essence, Merrill's "equity " investment was guaranteed to be repaid in 6 months at a stated 15 % rate of return, in addition to ENRON paying a $225,000 fee when the documents were signed, and agreeing to compensate Merrill for all its expenses of drawing up the legal papers for the transaction. (As a professor of finance and investments, this "deal" sounds a lot to me like a guaranteed "loan" at a fixed rate of interest, and not a real "equity" position with price risk to the investor.) But where were the various credit agencies that were supposed to provide independent advice about ENRON's financial ability to repay its indebtedness? Moody's and Standard and Poor's credit ratings indicated that ENRON was an "investment grade" credit risk until well into the year 2001, although the rating was softening. The massive restatement of financial statements in October, 2001, and further insights into the "off balance sheet" financing methods of ENRON led to ratings downgrades to "junk" or high risk status of ENRON as a creditor. However, even the credit rating agencies, with their supposed accounting and analytical expertise, failed to fully understand the condition of ENRON and to give early warning of the potential failure to the investing public and financial institutions. Where were the government's regulatory agencies? The Securities and Exchange Commission, our federal government oversight of publicly traded companies and the securities markets, were apparently caught flat-footed with the ENRON October, 2001, revelations. The State of California deregulated electric energy with a plan that established the rules for energy trading and pricing, but the rules were apparently so complex that there was an incentive for energy producers and trading companies to "game the system" in order to make profits by finding loopholes in the system. The California energy deregulation also had some interesting characteristics, such as, the energy

prices to consumers were fixed in price, but the firms transmitting energy to consumers would have to pay an energy price which was deregulated and adjusted to prevailing market conditions. Could the politicians have also been unwitting partners in the ENRON failure? And lets not fail to identify the role of ENRON rank-and-file employees and the general investing public. ENRON employees were seeing the day-to-day company operations up close and personal. The accounting department had hundreds of professionally trained accountants working on the reporting of company transactions. Many of the accountants were also prior employees of the auditing firm, Arthur Andersen, trained to look at the transactions with an "independent" auditor's perspective. Finally, one employee, Sherron Watkins, did attempt to blow the whistle on suspected accounting problems, but only in an anonymous communication to the CEO of ENRON. And what was driving the executives of ENRON to do the things that are now linked to the failure of the company? The obvious answer was a desire to satisfy the profit and stock price expectations of the investing public, in an effort to fulfill the corporate objective, as stated in the financial management texts, to "maximize the value of the firm to the shareholders". In the 1990's, investors in equity securities became enamored with the expectation of 25-30% annual rates of returns, and rewarded companies with fast growing earnings with very rich stock prices, but also severely punished company stocks which failed to meet the "Wall Street's" expected next period earnings numbers. Can you say investor "greed"? As a result, ENRON executives and employees were caught up in the desire to report ever increasing earnings in order to keep stock prices rising, and to protect their jobs and wealth in their retirement plans. In summary, who caused the ENRON failure? Answer: a lot of individual and institutional players! While it may be comforting to just fix blame on a few "rotten apples" in the company, there are a lot more cooks who contributed to the terrible stew served by ENRON. We will see later who is "legally" to blame, once the legal process works its way through the court system.

ENRON Failure: How did it happen? The precipitous public event that really led to the ENRON failure was most likely the announcement of the financial and profit restatements in October, 2001. But this was just the "tip of the iceberg". The real explanation lies in the operations and activities of ENRON for many years leading up to October, 2001. Pivotal to this was the nature of the change in ENRON's business activities, from that of a producer and transporter of energy, to a global marketer and trader of energy, with production and trading of energy, energy financial derivatives products, and telecommunications systems and other derivative products trading. ENRON was even developing new financial products on weather and corporate credit enhancement, i.e., financial contracts that would make payments based on outcomes of weather and changes in the credit worthiness of businesses. However, the issue of accounting and auditing for these new activities, and the increasing use of off-balance-sheet partnerships and financing activities are intricately entwined with the issue of how the failure occurred. And finally, the corporate, economic and political environment impact should be included as contributing factors. It is likely that books and learned tomes will be written on this topic for years to come, so I will only raise the issues I see as key to how ENRON descended so quickly into bankruptcy. The birth of ENRON in 1985 was as a company that transmitted natural gas to customers through its physical pipeline system. It built pipelines with long physical lifetimes, and used debt capital to raise money for the construction of the facilities. Government regulation, at the state and federal level, of energy companies and prices was very comprehensive. But there was a trend in government and economic policy to deregulate the industry and let market forces prevail, which would also change the risk and reward characteristics of the companies in this industry. The move toward deregulation also opened up new possibilities for company activities and products. ENRON embarked on the development of financial products and commodities trading platforms (EnronOnline) that moved the company toward becoming a financial services and information technology based business enterprise. Producing energy and transporting it to the end user was the boring, old line of business, with limited growth potential and investor appeal.

ENRON's new focus on becoming a global marketer and trader of energy and other financial products was the new wave that would offer prospects of rapidly growing earnings and stock prices for the shareholders. But, the new operational environment involved the need to finance development of entirely new business activities, and changed the characteristics of funds flowing into and out of the company. Risks to ENRON from this new corporate strategy would include variability of funds needed to finance the new activities, the variability of economic profits caused by new market factors, and complexity of implementing accounting systems to handle the new products/businesses. So ENRON needed new capital sources with which to invest in its new corporate direction. This would change in the future the ability of the company to meet its financial obligations to those providing the new capital. Banks and bondholders would be providing loans with interest and principal repayment obligations fixed by legal contract, with well-defined risks and penalties if repayment was not made. Equity investors buying newly issued shares of ENRON stock were making decisions based on future expected profits and risks quite different from that of an energy production and transportation company. Future returns to purchasers of these new ENRON shares would be dependent on the success of the new corporate strategic investments. With this background, Lay and Skilling, with the advice and consent of the members of the Board of Directors (elected, in theory, by and for the interests of the stockholders) proceeded to implement the new corporate strategy. A new employee, Fastow, was brought to the firm from the banking industry and rose to become the Chief Financial Officer. Together, Lay, Skilling and Fastow had the responsibility to conduct the financing, accounting and operating activities of the company as it transformed itself in the corporate future. The pressure on this management team was to bring about the transformation of the company, to produce growing profits from old and new operations, and to grow the value of the firm, as indicated by the market price of its common stock. The stage was set. ENRON's business transformation was firmly set in place in the middle and late 1990's. However, new markets and new products bring new risks and new competitors. Forecasts of how much new financing is needed to fund the new activities may prove to be too low. More new capital must be

raised from external capital sources. Lenders want assurance that loans can and will be repaid, determined partly by the credit agency ratings on the company, which are based on the company's reported financial statements which are given the seal of approval by the public auditors. Investors purchasing new shares of ENRON stock will only be rewarded if the stock price continues to rise, but that largely depends on the company continuing to produce ever higher reported after tax accounting profits. So reality sets in. The company discovers that the new investments are not as profitable as forecasted or desired. The financial officer is responsible for raising continuously increasing amounts of new capital to fund the growing investments required to fulfil the new corporate strategy. Wall Street securities analysts expect to see growing assets and growing corporate revenues being reflected in the after tax reported profits and earnings per share (EPS). The management team must deliver new capital to meet needs, must continue to pay and meet its past loan repayments, and must deliver the bottom line income numbers on the profit statement. How do you accomplish this when the underlying economics of the business is short of expectations? One answer is to adjust the corporate operations to reflect the changed economic environment (potentially disappointing the shareholders of the company and having the senior management team replaced by the Board of Directors). The other answer is to find ways to raise the new capital without it appearing adversely on the firm's financial statements, and to find accounting methodologies that will allow stated profit reports to investors to be inflated beyond the true level of what would be called "economic" profits for the firm. The information and legal accusations regarding ENRON seem to indicate that management took the latter course of action. The results of the Lay-Skilling-Fastow leadership decisions embarked ENRON on a path of using available accounting devices to both understate the amount of borrowed capital actually being used by the company, and to "manufacture" higher after tax reported profits and EPS to shareholders. The issue of whether these were legal or illegal actions awaits the outcome of future court trials, but the fact that ENRON is now in the legal condition of Chapter 11 bankruptcy, with the massive losses in stock value and uncertainty about lenders being repaid, is the result of the course of action set

in place by ENRON's executive officers ( who were aided and abetted to some extent by members of the Board of Directors, Arthur Andersen and various outside law firms). The story of HOW this occurred is very complex. I will attempt to explain several of the techniques used by ENRON to under-report the debt required to keep the company operations running and to overstate the profits of the firm. Both goals were achieved with the creation of Special Purpose Entities (SPE's or partnerships). A company can enter into a partnership with outside investors and lenders, and not have to consolidate that entity into the company's financial statements reported to the investing public. So, ENRON establishes a partnership with outside equity investors who buy as little as 3 percent of the partnership's total capital, with ENRON investing the rest of the capital. Next, the partnership buys assets from ENRON, using the equity capital from the partners and loans from a financial institution or bank. As a simplified illustration, assume that ENRON sells electric generating equipment to a SPE for a price of $50 million. Banks lend the SPE $45 million for the purchase with a fixed maturity and interest rate. ENRON invests $0.5 million in equity of the SPE and sells shares for $4.5 million (over 3 percent of total capital) to outside investors. Because the bank loan is not directly to ENRON, but to the SPE, it does not get reported as a debt obligation on the balance sheet. Further, if the assets book value on ENRONs balance sheet for this equipment was $28 million at the time of the sale to the SPE, then ENRON now can report in this fiscal year a profit on the sale of $50-$28=$22 million of profits. ENRONs cash receipt from the SPE is $50 million minus its equity investment in the SPE equity ($49.5 million net new cash to ENRON). If the SPE successfully uses the asset to generate future cash inflows to repay the loan to the bank and have remaining profits for the SPE partners, then ENRON will book future profits. But what happens if the assets are overpriced and do not generate sufficient future revenues to repay the bank loan? Does this mean that the banks might not get repaid the principal of the loan? The answer lies in what might have been a separate agreement, oral or written, that ENRON promised to the banks that loaned money to the SPE. The agreement might look like the following. ENRON will agree to give to the SPE (or directly to

the banks) additional shares of ENRON stock in sufficient market value for the SPE to sell the stock and repay the bank loan principal. This action might also be required in the case where ENRON either has a downgrade of its own credit rating below investment grade, or when the ENRON stock price falls to a lower boundary level. Therefore, when the market price reaches $28 per share, ENRON must give the SPE enough shares of stock to enable the SPE to repay all of the outstanding bank loan principal. However, if ENRON fails to inform its stockholders about these future obligations, the massive amounts of new shares that ENRON would have to issue would cause high equity dilution, immediately lower the EPS of the stock, and further put downward pressure on the market price of ENRON stock. Since ENRON by year 2000 had created approximately 2000 SPEs, any major reversal of the companys operations would be cataclysmic. The above illustration shows how ENRON was able to use the SPEs to enter into debt obligations with lenders, and still not report the debt on its own financial balance sheet. Further, the company could use the sales of its assets and operations to the SPE to generate an immediate profit to add to its current income statement. Now, in keeping with the classic type of Ponzie scheme, you start with small deals to boost profits and hide small amounts of debt off-balance sheet. To grow next years earnings, support investment in additional assets and new businesses and repay the old lenders, you need to create more and bigger SPEs in the second year, then the third year, etc. As long as increasing stock prices continue, everything is fine. When lenders dont get repaid or stock trigger points are reached in the loan agreements, then things start to unravel quickly and in the full glare of the investors, security analysts and credit rating agencies. For ENRON, activities undertaken over many years came to public attention in October, 2001, and the company was taken into bankruptcy by December of that year. In addition to the creation of the SPEs, ENRON seemed to be equally busy creating the appearance of corporate profits from other aggressive uses of accounting. One method of boosting reported earnings after taxes to shareholders is to find ways to lower the corporate tax bill on reported profits. Because GAAP and tax accounting rules can be quite different, it might be possible for a creative company to raise reported after- tax

profits using GAAP accounting, but using different rules to report zero profits for government tax purposes. To the shareholders in the annual report, following GAAP rules, the company would report its higher pre-tax profits, while reporting the taxes payable at a much lower amount. One report suggests that of ENRONs year 2000 earnings after-tax reported to shareholders, about $296 million or 30 % of earnings were the result of one-time tax saving strategies created by the tax accountants. Clearly, companies can follow rules that allow them to minimize taxes payable to government. And, with the complexity of US corporate tax codes and the added factor that ENRON was a global company facing many different country taxes, bright tax accountants can contribute significantly to lowering the companys total tax bill. By September of 2001, reports indicate that lowered operating profits in many of ENRONs divisions resulted in pressure on the tax department to generate up to $600 million of new tax savings for fiscal year 2001. Accountants know that strategies to avoid excess tax payments are legal, but that attempts to evade taxes by fraudulent means is illegal. Here again, ENRON's internal staff likely made use of legal opinions from internal and external legal advisors that their techniques were "appropriate". These several examples indicate the potential methods by which aggressive application of accounting can hide debt off-balance sheet and create the appearance of increasing profits. The result can have the effect of convincing investors that the company stock is more valuable than it might truly be worth. But these methods, when learned about by the investing public and the creditors, can lead to rapid deterioration of the company and the value of its common stock shares. Reports in the media about ENRON suggest that the reliability of the company balance sheet and income statements in the annual reports to the SEC and the shareholders over the previous 3 to 4 years were highly dependent on the aggressive and creative skills of ENRONs accounting staff, aided by the acquiescence of the Arthur Andersen auditors, and the counsel of legal firms hired by ENRON.

ENRON Failure: Why did it happen? I think that the answer to why it happened is relatively straightforward. The Lay-Skilling- Fastow executive team was trying to create a business enterprise that would deliver increasing wealth for their shareholders. However, when the cold light of dawn showed that the real economics of the firm was less than that desired or necessary to support a growing stock price, it became necessary for the firm to apply aggressive accounting methods to achieve the desired effect. To the extent that the new business ventures undertaken required continuously increasing amounts of new capital, the executive team relied on other creative mechanisms and accounting to bring in new debt capital, but to do it in a way that would not make the firm look to be more risky to the new capital investors. Once started down a slippery slope, the need to continue these types of activities simply increased in each succeeding year. They wanted to keep their jobs, personal wealth and public acclaim, which meant keeping ENRON moving forward by any means. But where were the ethical checks and balances that should have been recognized by management? Which brings me to the ENRON Board of Directors. Where was the corporate governance process that should have been exercised by the members of the Board? Certainly the Audit Committee of the Board should have been more critical of the auditors and their work. But, with the stock price and earnings rising, they were perhaps lulled into a false sense of security about ENRONs internal accounting, and the favorable opinion letters signed by Arthur Andersen. The Board members enjoyed their status at ENRON and the remuneration paid by ENRON. They seemed willing to accept information from the Lay-SkillingFastow team at face value, without critical analysis. They failed to live up to their role as overseers of management on behalf of the stockholders who elected them to the Board. ENRON employees also facilitated the failure of their own company, and have suffered accordingly. ENRON had an inside legal staff of over 100 lawyers, and an accounting staff of several hundred trained accountants. All seemed to

be operating in a way that supported the executive management team. There seemed to be little incentive or willingness to question the methods being employed to boost reported profits and hide corporate debt. As employees were being paid good salaries, provided with full benefits, and investing their pension contributions in rising company stock, rocking the boat about questionable activities would be a supreme act of courage, with high risk penalties. So they remained supportive, until Sherron Watkins finally tried to raise awareness of potential problems. ENRON executives were further aided and supported by the Arthur Andersen auditors and scores of outside legal firms working for the company. ENRON was a very good client for Arthur Andersen, collecting over $50 million in revenues in year 2000. The legal firms were paid about $50 million in fees for their services that supported and justified the activities of ENRON. Remaining in good standing with the executive team at ENRON meant future business for their firms, and perhaps added bonuses for individual executives at the auditing and the legal firms. Executives probably do not look favourably on outside firms who give contrary advice to that which the executives desire. So ENRON may not have been receiving the negative responses that would have cut short the activities that ultimately brought ENRON down. Whether illegal activities occurred is the subject of future investigations involving the auditing and legal firms hired by ENRON. The government also bears some responsibility. The federal budget for the SEC has been reduced in past years, while the number and complexity of companies to be overseen by the SEC has increased. Politicians have reversed SEC enforcement rules through the legislative process, as seen in the debate over the rule of having companies expense options grants to employees in the income statement. Legislative activities have reduced regulatory oversight of energy companies, and replaced old regulations with new sets of rules and procedures that are only tested later in the real world, and sometimes found not to achieve the intended economic consequences. I wont even raise the issue of campaign contributions to the politicians by individuals and corporations!

And finally, how the ENRON failure resulted must be viewed in relation to the desires of investors and financial institutions. Investors in the markets created conditions that meant companies which appeared to be winners saw rapid stock price increases, while poor performers had plunging stock prices. Pressure on company management was intense to continue to be seen as a winner to drive prices higher for their stockholders. Risk evaluation of stocks seemed to be secondary to investors relative to higher reported earnings per share. In addition, the banks and security brokerage firms wanted to do business with ENRON to generate profits (and perhaps individual annual bonuses for the employees doing the ENRON deals) for their own shareholders. It seems evident, based on information concerning ENRONs SPE activities, that the financial institutions benefited from the relationship, while they took steps to reduce the risks of dealing with ENRON through separate side deals and guarantees that were not fully understood by or revealed to the investing public.

In summary, the ENRON failure has not been the result of just questionable activities by ENRONs executive management team. The cast of contributors to the failure and bankruptcy are both inside and outside the company. Its th e total system that resulted in failure that needs to be further understood and investigated.