Order Code RS21135
February 4, 2002
CRS Report for Congress
Received through the CRS Web
The Enron Collapse:
An Overview of Financial Issues
Mark Jickling, Coordinator
Specialist in Public Finance
Government and Finance Division
Summary
Only months before Enron Corp.’s bankruptcy filing in December 2001, the firm
was widely regarded as one of the most innovative, fastest growing, and best managed
businesses in the United States. With the swift collapse, shareholders, including
thousands of Enron workers who held company stock in their 401(k) retirement
accounts, lost tens of billions of dollars. Investigations of wrongdoing may take years
to conclude, but Enron’s failure already raises financial oversight issues with wider
applications. Why didn’t the watchdogs bark? This report briefly examines the
accounting system that failed to provide a clear picture of the firm’s true condition, the
independent auditors and board members who were unwilling to challenge Enron’s
management, the Wall Street stock analysts and bond raters who missed the trouble
ahead, the rules governing employer stock in company pension plans, and the
unregulated energy derivatives trading that was the core of Enron’s business. The report
will be updated regularly as further reliable information about Enron’s downfall – which
is now extremely limited – becomes available.
Other contributors to this report include Bob Lyke, Patrick Purcell, and Gary Shorter.
Formed in 1985 from a merger of Houston Natural Gas and Internorth, Enron Corp.
was the first nationwide natural gas pipeline network. Over time, the firm’s business focus
shifted from the regulated transportation of natural gas to unregulated energy trading
markets. The guiding principle seems to have been that there was more money to be made
in buying and selling financial contracts linked to the value of energy assets (and to other
economic variables) than in actual ownership of physical assets.
Until late 2001, nearly all observers – including professional Wall Street analysts –
regarded this transformation as an outstanding success. Enron’s reported annual revenues
grew from under $10 billion in the early 1990s to $101 billion in 2000, ranking it seventh
on the Fortune 500.
The unraveling began in August 2001, when CEO Jeffrey Skilling resigned for
undisclosed reasons. On October 16, Enron reported its first quarterly loss in 4 years,
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taking a charge against earnings of $1 billion for poorly performing businesses. The
reported third quarter loss was $618 million, versus a $292 million profit a year earlier.
On November 8, the company announced in a Securities and Exchange Commission (SEC)
filing that it was restating its earnings since 1997 – reducing them by $586 million. The
coup-de-grace came on November 28, when the major bond rating agencies downgraded
Enron’s debt to below-investment-grade, or junk bond status. The company filed for
Chapter 11 bankruptcy on December 2, 2001.
Several committees in the House and Senate have held or plan to hold hearings
related to Enron’s fall. The Justice Department is conducting a criminal investigation.
The challenge for financial oversight, however, does not depend on findings of
wrongdoing. Even if no one at Enron did anything improper, the swift and unanticipated
collapse of such a large corporation suggests basic problems with the U.S. system of
securities regulation, which is based on the full and accurate disclosure of all financial
information that market participants need to make informed investment decisions.
The overarching financial issue raised by Enron is whether the quality of information
available about public corporations needs to be improved. Several aspects of this central
issue are briefly sketched below, with references to CRS products that discuss the issues
in more detail.
Auditing Issues
Federal securities law requires that the accounting statements of publicly traded
corporations be certified by an independent auditor. Enron’s outside audits have received
much attention. While external audits do not prevent corporations from making financial
mistakes, let alone bankruptcy, problems with recent Enron audits may have contributed
to both the rapid rise and the sharp fall in its stock price. Outside investors, including
financial institutions, may have been misled about the corporation’s net income (which
was subsequently restated) and contingent liabilities (which were far larger than generally
known). The auditor, Arthur Andersen, has admitted some mistakes. Andersen fired the
partner in charge of Enron audits on January 15, 2002, and Enron dismissed Andersen on
January 17. One issue is whether Andersen’s extensive consulting work for Enron may
have compromised its judgment in determining the nature, timing, and extent of audit
procedures and in asking that revisions be made to financial statements, which are the
responsibility of Enron’s management. Questions have also been asked about Andersen
destroying documents and e-mails related to its audits. Oversight of auditors has primarily
rested with the American Institute of Certified Public Accountants (a nongovernmental
trade group) and state boards of accountancy. On January 17, 2002, the Chairman of the
Securities and Exchange Commission (SEC) proposed a new oversight board that would
be responsible for disciplinary actions.
See also: CRS Report RS21120, Auditing and its Regulators: Proposals for Reform After
Enron,
by Bob Lyke.
CRS Report RS20707, Auditor Independence: The SEC’s 2000 Rulemaking, by Mark
Jickling.

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Accounting Issues
The Enron controversy involves several accounting issues. One concerns the rules
governing whether the financial statements of special purpose entities (SPEs) established
by a corporation should be consolidated with the corporation’s financial statements; for
certain SPE partnerships at issue, consolidation is not required if among other things an
independent third party invests as little as 3% of the capital, a threshold some consider too
low. A second issue concerns the latitude allowed in valuing derivatives, particularly non-
exchange traded energy contracts. Third, there are calls for improved disclosure, either
in notes to financial statements or a management discussion and analysis, especially for
financial arrangements involving contingent liabilities. Accounting standards for
corporations are set by the Financial Accounting Standards Board (FASB), a non-
governmental entity, though there are also SEC requirements. (The SEC has statutory
authority to set accounting standards for firms that sell securities to the public.)
For additional information contact Bob Lyke 7-7355.
Pension Issues
Like many companies, Enron sponsors a retirement plan – a “401(k)” – for its
employees to which they can contribute a portion of their pay on a tax-deferred basis. As
of December 31, 2000, 62% of the assets held in the corporation’s 401(k) retirement plan
consisted of Enron stock. Many individual Enron employees held even larger percentages
of Enron stock in their 401(k) accounts. Shares of Enron, which in January 2001 traded
for more than $80/share, were worth less than 70 cents in January 2002. Consequently,
the company’s bankruptcy has substantially reduced the value of its employees’ retirement
accounts. The losses suffered by participants in the Enron Corporation’s 401(k) plan have
prompted questions about the laws and regulations that govern these plans. Should there
be a limit on the amount of employer stock that a 401(k) plan can hold? Should
companies be allowed to restrict the sale of stock that they contribute to the plans?
Should the guarantees that the Pension Benefit Guarantee Corporation extends to
traditional “defined benefit” plans also apply to 401(k)’s?
See also: CRS Report RS21115, The Enron Bankruptcy and Employer Stock in
Retirement Plans
, by Patrick Purcell.
CRS Report RL30122. Pension Sponsorship and Participation: Summary of Recent
Trends,
by Patrick Purcell.
Corporate Governance Issues
The role of a company’s board of directors is to oversee corporate management to
protect the interests of shareholders. However, in 1999 Enron’s board waived conflict
of interest rules to allow chief financial officer Andrew Fastow to create private
partnerships to do business with the firm. These partnerships appear to have concealed
debts and liabilities that would have had a significant impact on Enron’s reported profits.
Enron’s collapse raises the issue of how to reinforce directors’ capability and will to
challenge questionable dealings by corporate managers.

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Specific questions involve independent, or “outside” directors. (Stock exchange rules
require that a certain percentage of board members be unaffiliated with the firm and its
management.) Should the way outside directors are selected be changed or regulated?
Should there be restrictions on indirect compensation in the form of, say, consulting
contracts or donations to other institutions where independent board members serve?
Should the personal liability of directors in cases of corporate fraud be increased? Do the
rules requiring members of the board’s audit committee to be “financially literate” ensure
that the board will grasp the innovative and complex financial and accounting strategies
employed by companies like Enron?
For additional information contact Gary Shorter 7-7772.
Securities Analyst Issues
Securities analysts employed by investment banks provide research and make “buy,”
“sell,” or “hold” recommendations for the use of their sales staffs and their investor clients.
These recommendations are widely circulated and are relied upon by many investors
throughout the markets. Analyst support was crucial to Enron because it required
constant infusions of funding from the financial markets. On November 29, 2001, after
Enron’s stock had fallen 99% from its high, and after rating agencies had downgraded its
debt to “junk bond”status, only two of 11 major firm analysts rated its stock a “sell.” This
performance added to concerns that were raised in 2000 in the wake of the “dot.com”
stock crash. Is analyst objectivity compromised by pressure to avoid alienating lucrative
investment banking clients? Are regulations needed to require disclosure of analysts’
personal holdings or their employers’ dealings with the firms they cover, or to prohibit the
linking of analyst pay to investment banking profits? Should analysts’ performance and
qualifications be monitored by the SEC or by a self-regulatory organization such as the
National Association of Securities Dealers (NASD)?
For additional information contact Gary Shorter 7-7772.
Derivatives Issues
The core of Enron’s business appears to have been dealing in derivative contracts
based on the prices of oil, gas, electricity and other variables. For example, Enron sold
long-term contracts to sell energy at fixed prices. These contracts allow the buyers to
avoid, or hedge, the risks that increases (or drops) in energy prices posed to their
businesses. Since the markets in which Enron traded are largely unregulated, with no
reporting requirements, little information is available about the extent or profitability of
Enron’s derivatives activities. Did Enron earn money from dealer commissions and
spreads, or was it actively speculating on future price trends? Speculative losses in
derivatives, perhaps masked by “creative” accounting, could have contributed to the firm’s
downfall. On the other hand, the trading operations may have been profitable and trouble-
free, and Enron’s financial difficulties the result of other unrelated operations.
Enron’s collapse raises the issue of supervision of unregulated derivatives markets.
Would it be useful if regulators had more information about the portfolios and risk
exposures of major dealers in derivatives? Although Enron’s bankruptcy appears to have
had little impact on energy supplies and prices, a similar dealer failure in the future might

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damage the dealer’s trading partners and its lenders, and might set off widespread
disruptions in financial and/or real commodity markets.
See also: CRS Report RS20560, Derivatives Regulation: Legislation in the 106th
Congress
, by Mark Jickling.