The story of Enron serves as a prime example of how financial engineering was employed at such a

magnificent level at a publicly-traded company to defraud employees, customers, investors,

creditors, and shareholders alike. Enron employed rather sophisticated financial engineering
techniques to hide losses from investors and creditors and superficially prop up the stock price of
Enron. One of the techniques that Enron used was an accounting practice called mark-to-market
accounting. Enron started to use mark-to-market accounting for its energy trading business. With
mark-to-market accounting, Enron would measure the value of a security based on the fair market
value of the security, instead of the security’s book value. The problem with mark-to-market
accounting, especially in the energy trading business, is that since there wasn’t any quoted prices
upon which to base the valuation of these securities, Enron was free to develop and use whatever
valuation models fit its own assumptions and methods. This practice made it look like Enron was
being profitable when it was losing money. For example, Enron would build physical assets such as
the Dabnol power plant in India and would claim as revenue the projected profits on that plant. Due
to India’s economics at the time the power plant never came into operation and did not earn any
revenues. This did not prevent Enron’s senior executives from immediately treating the projected
earnings as realized earnings. If similar projects to the power plant in India earned less than the
projected amount, then Enron would transfer the asset to an off-balance-sheet account, thus creating
a subsidiary. Without realizing any of the losses of these subsidiaries Enron’s bottom line would
never me adversely affected.

Andrew Fastow, the company’s Chief Financial Officer, created these unique accounting schemes
whereupon he would use off-balance-sheet special purpose entities (SPEs) to raise capital, hedge risk
and hide debt and losses from assets that were not earning revenue as projected. The SPEs would be
created as limited partnerships with outside parties, mainly financial institutions. Andrew Fastow
would use these SPEs to borrow money from the financial institutions to purchase assets without the
debt or assets showing up in the company’s financial statements. Essentially, Andrew was
transferring whatever assets did not make money off the balance sheet and into these special
purpose entities, thus allowing Enron to hide accounting realities, instead of operating results. The
SPEs became a focal point in the downfall of Enron. Andrew Fastow would capitalize these SPEs not
just with hard assets and liabilities, but with complex derivative instruments – its own restricted
stock. As the value of the stock fell, Enron was forced to issue more stock in order to compensate
investors for the downside risk.

Enron’s rise was the direct result of federal deregulation of natural gas pipelines which Enron, under
the leadership of Kenneth Lay, fought hard for. But the rise of Enron brought with it something new
– the creation of the energy derivative, a futures contract based on the value of the underlying asset,
that being the price of energy. With the help of Jeffrey Skilling, Enron became a sort of “gas bank”
where it would buy gas from a network of suppliers and sell it to a network of consumers,
contractually guaranteeing both the supply and the price, charging fees for the transactions and
assuming the associated risks. This concept completely revolutionized the energy industry. With the
gas bank model being so successful senior executives decided to apply the concept to the market for
electric energy. Kenneth Lay, then the CEO of Enron, and Jeffrey Skilling went around the country
selling this concept to power companies and energy regulators and lobbying for the deregulation of
electric utilities as well. The deregulation of electric utilities made it possible for Enron to create a
market for electric contracts.

Enron also pioneered the creation of an electronic commodities trading platform, Enron Online. This
opened the door for increased profits since a great deal of commodities trading was happening via
this platform where Enron was the counterparty to every transaction. Competitors started seeing
Enron’s success and copying from its playbook. Enron ultimately became one of the most admired
and innovative companies in the world.
The fall of Enron was sadder and much quicker than its rise and brought with it something tragical –
the human factor. With Enron’s demise employees lost their pensions and retirees lost their
retirement funds. 4,500 employees lost their jobs. Shareholder lost $74 billion in the four years
leading up to its bankruptcy. Most notably, however, aside from the human tragedy of Enron’s
demise was the dissolution of Arthur Andersen, the reputable accounting firm responsible for
auditing Enron’s financial statements. At some point during Enron’s precipitous fall Arthur
Andersen decided to shred Enron’s financial documents to conceal them from the SEC. This act
caused the SEC to charge Arthur Andersen with obstruction of justice. The fall of Enron also
contributed to the passage of the Sarbanes-Oxley Act. The Sarbanes-Oxley Act or the Corporate
Responsibility Act of 2002 mandated strict reforms to improve financial disclosures and prevent
accounting fraud.

I think that the best type of risk mitigation is the avoidance of risks. But in Enron’s case, senior
leaders acting ethically could have minimized the risk profile drastically. I think that Enron’s senior
leadership either turned a blind eye to the increased risk tolerance or encouraged that type of
behavior. We learn from the case study and the documentary that that is exactly what Enron did. I
think Enron’s senior executives were not motivated by being ethical, but by hubris, greed, seeming
profitable and share price increases.

One recommendation could have been an independent audit committee not made up of former
Arthur Andersen employees and monitored by the Board of Directors. I think that Kenneth Lay and
Jeffrey Skilling should have never allowed the SPEs to be created to transfer non-performing assets
to them. The SEC should have also kept a close watch on Enron after two Enron traders were
charged for committing fraud. The mark-to-market accounting rules should have not been granted to
Enron since there was no quoted prices for the energy contract and derivative instruments. Another
recommendation is that the off-balance-sheet proposed by Andrew Fastow should not have been
allowed. The off-balance-sheet accounting is what ultimately made Enron an house of cards.