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Collapse of a Wall Street Darling By the summer of 2001, Enron was in a free fall. CEO Ken Lay had
retired in February, turning over the position to Skilling, and that
By the fall of 2000, Enron was starting to crumble under its own August, Jeff Skilling resigned as CEO for "personal reasons." Around
weight. CEO Jeffrey Skilling had a way of hiding the financial losses the same time, analysts began to downgrade their rating for
of the trading business and other operations of the company; it Enron's stock, and the stock descended to a 52-week low of
was called mark-to-market accounting. This is a technique used $39.95. By Oct.16, the company reported its first quarterly loss and
when trading securities where you measure the value of a security closed its "Raptor" SPE, so that it would not have to distribute 58
based on its current market value, instead of its book value. This million shares of stock, which would further reduce earnings. This
can work well for securities, but it can be disastrous for other action caught the attention of the SEC.
businesses.
A few days later, Enron changed pension plan administrators,
In Enron's case, the company would build an asset, such as a essentially forbidding employees from selling their shares, for at
power plant, and immediately claim the projected profit on its least 30 days. Shortly after, the SEC announced it was investigating
books, even though it hadn't made one dime from it. If the Enron and the SPVs created by Fastow. Fastow was fired from the
revenue from the power plant were less than the projected company that day. Also, the company restated earnings going
amount, instead of taking the loss, the company would then back to 1997. Enron had losses of $591 million and had $628 million
transfer these assets to an off-the-books corporation, where the loss in debt by the end of 2000. The final blow was dealt when Dynegy
would go unreported. This type of accounting enabled Enron to (NYSE: DYN), a company that had previously announced would
write off losses without hurting the company's bottom line. merge with the Enron, backed out of its offer on Nov. 28. By Dec. 2,
2001, Enron had filed for bankruptcy.
The mark-to-market practice led to schemes that were designed to
hide the losses and make the company appear to be more Enron Gets a New Name
profitable than it really was. To cope with the mounting losses,
Andrew Fastow, a rising star who was promoted to CFO in 1998, Once Enron's Plan of Reorganization was approved by the U.S.
came up with a devious plan to make the company appear to be Bankruptcy Court, the new board of directors changed Enron's
in great shape, despite the fact that many of its subsidiaries were name to Enron Creditors Recovery Corp. (ECRC). The company's
losing money. new sole mission was "to reorganize and liquidate certain of the
operations and assets of the 'pre-bankruptcy' Enron for the benefit
How Did Enron Use SPVs to Hide its Debt? of creditors." The company paid its creditors more than 21.7 billion
from 2004-2011. Its last payout was in May 2011.
Fastow and others at Enron orchestrated a scheme to use off-
balance-sheet special purpose vehicles (SPVs), also know as Enron Execs and Accountants Prosecuted
special purposes entities (SPEs) to hide mountains of debt and toxic
assets from investors and creditors. The primary aim of these SPVs Once the fraud was discovered, two of the preeminent institutions
was to hide accounting realities, rather than operating results. in U.S. business, Arthur Andersen LLP, and Enron Corp. found
themselves facing federal prosecution. Arthur Andersen was one of
The standard Enron-to-SPV transaction occurred when Enron the first casualties of Enron's prolific demise. In June 2002, the firm
transferred some of its rapidly rising stock to the SPV in exchange was found guilty of obstructing justice for shredding Enron's
for cash or a note. The SPV would subsequently use the stock to financial documents to conceal them from the SEC. The conviction
hedge an asset listed on Enron's balance sheet. In turn, Enron was overturned later, on appeal; however, despite the appeal, like
would guarantee the SPV's value to reduce apparent counterparty Enron, the firm was deeply disgraced by the scandal.
risk.
Several of Enron's execs were charged with a slew of charges,
Enron believed that its stock price would keep appreciating a including conspiracy, insider trading, and securities fraud. Enron's
belief similar to that embodied by Long-Term Capital Management founder and former CEO Kenneth Lay was convicted of six counts
before its collapse. Eventually, Enron's stock declined. The values of of fraud and conspiracy and four counts of bank fraud. Prior to
the SPVs also fell, forcing Enron's guarantees to take effect. One sentencing, though, he died of a heart attack in Colorado.
major difference between Enron's use of SPVs and standard debt
securitization is that its SPVs were capitalized entirely with Enron Enron's former star CFO Andrew Fastow plead guilty to two counts
stock. This directly compromised the ability of the SPVs to hedge if of wire fraud and securities fraud for facilitating Enron's corrupt
Enron's share prices fell. Just as dangerous and culpable was the business practices. He ultimately cut a deal for cooperating with
second significant difference: Enron's failure to disclose conflicts of federal authorities and served a four-year sentence, which ended
interest. Enron disclosed the SPVs to the investing publicalthough in 2011.
it's certainly likely that few understood even that much but it
failed to adequately disclose the non-arm's length deals between Ultimately, though, former Enron CEO Jeffrey Skilling received the
the company and the SPVs. harshest sentence of anyone involved in the Enron scandal. In
2006, Skilling was convicted of conspiracy, fraud, and insider
Arthur Andersen and Enron: Risky Business trading. Skilling originally received a 24-year sentence, but in 2013
his sentence was reduced by ten years. As a part of the new deal,
In addition to Andrew Fastow, a major player in the Enron scandal Skilling was required to give $42 million to the victims of the Enron
was Enron's accounting firm Arthur Andersen LLP and its partner fraud and to cease challenging his conviction. Skilling remains in
David B. Duncan, who oversaw Enron's accounts. As one of the five prison and is scheduled for release on Feb. 21, 2028.
largest accounting firms in the United States at the time, it had a
reputation for high standards and quality risk management.
Enron's collapse and the financial havoc it wreaked on its When filing under Chapter 11, a company may continue operating
shareholders and employees led to new regulations and legislation while creating a reorganization plan. The week before the filing,
to promote the accuracy of financial reporting for publicly-held WorldCom lined up $2 billion in debtor-in-possession financing from
companies. In July of 2002, then-President George W. Bush signed Citigroup, J.P. Morgan and G.E. Capital, allowing company
into law the Sarbanes-Oxley Act. The Act heightened the operations to continue while it was in bankruptcy. WorldCom
consequences for destroying, altering or fabricating financial intended to use the money for covering obligations such as new
records, and for trying to defraud shareholders. (For more on the services and employee wages.
2002 Act, read: How The Sarbanes-Oxley Act Era Affected IPOs.)
WorldCom elected Nicholas Katzenbach, a former U.S. attorney
The Enron scandal resulted in other new compliance measures. general and former general counsel of IBM Corp., and Dennis R.
Additionally, the Financial Accounting Standards Board (FASB) Beresford, professor of accounting at the University of Georgia and
substantially raised its levels of ethical conduct. Moreover, a former chairman of the Financial Accounting Standards Board,
company's boards of directors became more independent, to its board of directors. The two served on a special investigative
monitoring the audit companies and quickly replacing bad panel for improving WorldComs accounting practices.
managers. These new measures are important mechanisms to spot
and close the loopholes that companies have used, as a way to TYCO
avoid accountability.
Tyco Corporate Scandal of 2002 (Ethics Case Analysis)
WORLDCOM
The case of Tycos corporate scandal of 2002 focuses on the
What is 'WorldCom' problem of unethical business practice and related issues. Tyco
was a large organization that grew through numerous acquisitions.
Formerly known as WorldCom, now known as MCI, this U.S.-based Tycos case shows that the problem was the unethical business
telecommunications company was the second-largest long- practices of a number of its top ranking officers, especially CEO
distance phone company in the country until a massive Kozlowski. Kozlowski was involved in numerous financial
accounting scandal that led to the company filing for bankruptcy transactions that were not included in the financial reports of the
protection in 2002. Most notably, company founder and former company. Kozlowski was also involved in unethical transactions
CEO Bernard Ebbers was sentenced to 25 years in prison, and with other Tyco officers and lower ranking employees to cover up
former CFO Scott Sullivan received a five-year jail sentence, which for Kozlowskis illegal financial transactions. Kozlowski even got
would have been longer had he not pleaded guilty and testified outsiders involved in the problem when his second wife received
against Ebbers. Under the bankruptcy reorganization agreement, money diverted from the firm. Court proceedings proved that
the company paid $750 million to the Securities and Exchange Kozlowski stole millions of dollars from Tyco, and that his illegal
Commission (SEC) in cash and stock in the new MCI, which was financial transactions were extensive. Kozlowski and other officers
intended to be paid to former investors. from Tyco were imprisoned. Tyco declined as investors lost
confidence in the company.
BREAKING DOWN 'WorldCom'
Major Ethics Issues in Tycos Case
In July 2002, WorldCom filed for Chapter 11 bankruptcy protection
in the Southern District of New York. Approximately one-month Tycos case shows that ethics issues can occur in different parts of
prior, an internal audit showed the company improperly an organization. Supposedly trusted leaders and executives with
accounted for $3.8 billion in operating expenses over five quarters. commendable background could exhibit unethical behavior and
After filing for bankruptcy, Sullivan was fired, senior vice president get involved in unethical practices. Even outsiders or third parties
and controller David Meyers resigned, and 17,000 workers were laid could get involved in these ethics issues. Thus, codes of ethics and
off. WorldCom's filing for bankruptcy, which did not include its relevant assessments of the organization must include employees
foreign units, is, as of 2016, the biggest in U.S. history. at all organizational levels, as well as significant third parties that
interact in operations. The major ethics issues in Tycos case were
WorldComs Revenue Begins Decreasing as follows:
Also, Kozlowski tried to avoid paying sales taxes for his art
purchases because doing so would raise red flags for authorities.
Sales taxes create formal records of financial transactions. In Tycos
case, the sales taxes amounted to millions because the purchased
art items were expensive. It would have been easier for authorities
to detect Kozlowskis illegal financial transactions because it was
unusual for Tyco officers like Kozlowski to make such big purchases
in a small amount of time.
It would have been possible for the board of directors to see the
adjustments taking place in programs at Tyco. This would have
been so if the board of directors had appropriate mindsets and
activity. Tycos programs were a weakness in the organization.
These programs provided benefits to officers and other employees.
The financial programs were opportunities for Kozlowskis illegal
financial transactions and unethical business practices.