Order Code RS21135
Updated July 24, 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
The sudden and unexpected collapse of Enron Corp. was the first in a series of
major corporate accounting scandals that has shaken confidence in the stock market and
perhaps the economy itself. Only months before Enron’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. It now appears that Enron was in
terrible financial shape as early as 2000, burdened with debt and money-losing
businesses, but manipulated its accounting statements to hide these problems. 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 also describes related
legislation that has received floor or committee action and will be updated regularly. An
indexed list of all Enron-related bills is available on the CRS website.
Other contributors to this report include William D. Jackson, 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, placing it seventh
Congressional Research Service ˜ The Library of Congress

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on the Fortune 500. Enron’s problems did not arise in its core energy operations, but in
other ventures, particularly “dot com” investments in Internet and communications
businesses and in certain foreign subsidiaries. Rather than recognize these problems, the
company engaged in dubious accounting tactics: it assigned business losses and near-
worthless assets to unconsolidated partnerships and “special purpose entities” to inflate
its reported bottom line, and may have disguised bank debt as energy derivatives trades
to conceal the extent of its indebtedness.
When these accounting fictions – which were sustained for nearly 18 months –
came to light, nearly all the profits reported since 2000 disappeared and Enron quickly
collapsed. (For an Enron timeline, see CRS Report RL31364, Enron: A Select
Chronology of Congressional and Government Activities
, by J. Michael Anderson.)
Nine committees in the House and Senate have held 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 Enron
and its outside accountants and lawyers had done nothing improper, the sudden collapse
of such a large corporation would suggest 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 central issue raised by Enron is transparency: how to improve the quality of
information available about public corporations. Several aspects of this issue are briefly
sketched below, with references to CRS products that provide 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. Outside investors, including financial institutions, may have been misled
about the corporation’s net income (which was subsequently restated) and its losses and
liabilities (which were far larger than reported). The auditor, Arthur Andersen, has been
convicted on criminal obstruction of justice charges, related to destruction of documents..
Oversight of auditors has primarily rested with the American Institute of Certified
Public Accountants (a nongovernmental trade group). There have been several proposals
– from the SEC, the Bush Administration, and in Congress – to create a new regulatory
organization responsible for disciplinary, quality-control, and/or independence oversight
of auditors. Common features of these proposals are that the board would review audits
and discipline auditors, under the oversight of the SEC, and that a majority of the new
body’s governing board would be from outside the accounting industry. H.R. 3763,
passed by the House in April 2002 and by the Senate (with an amendment in the nature
of a substitute) in June, would create such an oversight body. The conference on H.R.
3763 began on July 19, 2002, and is expected to approve something like the Senate
version, which gives the new board greater scope and authority than the House bill.
Another auditor issue is the provision of non-audit services to audit clients. Some
believe that provision of such services is a conflict of interest that tends to undermine the
arm’s-length, watchdog posture expected of the outside auditor. Some non-audit services
are prohibited by SEC regulations. H.R. 3763, as passed by the House, would direct the

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SEC to expand its list of prohibited services to include the provision of information
technology (IT) and internal audit services. The Senate version of H.R. 3763 includes the
IT and internal audit services ban, makes current SEC auditor independence regulations
a matter of statute, and requires the audit committee (or a delegated representative) of a
corporation’s board of directors to approve in advance the purchase of non-prohibited
non-audit services, except in certain cases (where the non-audit services cost less than 5%
of the total audit bill).
See also: CRS Report RS21120, Auditing and its Regulators: Proposals for Reform After
Enron,
by Bob Lyke.
CRS Report RL31483, Auditing and accounting reform proposals: a side-by-side
comparison,
by Mark Jickling.
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 use of derivatives to manipulate accounting results.
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. The SEC has proposed rules that would accelerate the filing of
quarterly and annual reports. H.R. 3763, in both House and Senate versions, calls for
calls for improved disclosure of transactions with unconsolidated subsidiaries and
“related-party” transactions. The House version of H.R. 3763 calls for “real-time”
reporting of certain events that are important to investors.
The overarching policy issue is whether current accounting rules permit corporations
to play “numbers games,” and whether investors are exposed to excessive risk by financial
statements that lack clarity and consistency. 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.) Some describe FASB’s
standards setting process as cumbersome and susceptible to business and/or political
pressures. The Senate version of H.R. 3763 would require that FASB be funded by
contributions from corporations that sell securities to the public (rather than the
accounting industry) and would require FASB to adopt procedures to ensure prompt
consideration of needed changes to accounting rules.
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

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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.
H.R. 3762, which passed the House on April 11, 2002, would, among other things,
require that account information be provided more often to plan participants; improve
access to investment planning advice; allow plan participants to sell company stock
contributed by employers after three years; and prohibit executives from selling company
stock while a plan is “locked down.” The latter provision is also included in H.R. 3763,
in both House and Senate versions.
See also: CRS Report RS21115, The Enron Bankruptcy and Employer Stock in
Retirement Plans
, 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. Transactions involving these partnerships
concealed debts and losses 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.
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?
Directors are elected by shareholders, but except in very unusual circumstances these are
“Soviet-style” elections, where management’s slate of candidates receives nearly
unanimous approval.
Should there be restrictions on indirect compensation in the form of, say, consulting
contracts or donations to charities 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?
Several bills before the 107th Congress would require prompt, electronic disclosure
of stock trades by corporate directors, senior executives, and other insiders – including
both House and Senate versions of H.R. 3763.
For additional information contact Gary Shorter (7-7772).

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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)?
H.R. 3763, as passed by the House, directs the SEC to study stock analyst issues and
to establish a confidential risk rating system for corporations that would determine how
frequently the SEC reviews companies’ financial statements. The Senate version of H.R.
3763 requires the NASD to adopt rules to regulate analysts and reduce conflicts of
interest.
See also: CRS Report RL31348, Enron and Stock Analyst Objectivity, by Gary
Shorter.
Banking Issues
One part of the fallout from Enron's demise involves its relations with banks.
Prominent banking companies, notably Citigroup and J.P. Morgan Chase, were involved
in both the investment banking (securities) and the commercial banking (lending and
deposit) businesses with Enron, and have suffered from Enron's collapse. The two
activities had been separated by the 1933 Glass-Steagall Act, until P.L. 106-102 (the
Gramm-Leach-Bliley Act) allowed their recombination. Observers have begun to question
whether that 1999 repeal of Glass-Steagall encouraged conflicts of interest and unsafe
bank lending in support of the investment banking business with Enron.

Several aspects of Enron's relations with its bankers have raised several questions.
(1) Do financial holding companies (firms that encompass both investment and
commercial banking operations) face a conflict of interest, between their duty to avoid
excessive risk on loans from their bank sides versus their opportunity to glean profits from
deals on their investment banking side? (2) Were the bankers enticed or pressured to
provide funding for Enron and recommend its securities and derivatives to other parties?
(3) Did the Dynegy rescue plan devised late in Enron's collapse, involving further
investments of J.P. Morgan Chase and Citigroup, represent protective self-dealing? (4)
What is the proper accounting for banks' off-balance-sheet items including derivative
positions and lines of credit, such as they provided to Enron? (5) Did the Enron situation
represent a warning that GLBA may need fine-tuning in the way it mixes the different
business practices of Wall Street and commercial banking?

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See also: CRS Report RS21188, Enron's Banking Relationships and Congressional
Repeal of Statutes Separating Bank Lending from Investment Banking
, by William D.
Jackson (7-7834).
Energy Derivatives Issues
Part of Enron’s core energy business involved dealing in derivative contracts based
on the prices of oil, gas, electricity and other variables. For example, Enron sold long-
term contracts to buy or 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, beyond what is contained in the company’s own financial
statements. While speculative trading in derivatives is an extremely high-risk activity, no
evidence has yet emerged that indicates that such losses were a factor in Enron’s collapse.
Since the Enron failure, several energy traders have admitted to making “wash
trades” which lack economic substance, but give the appearance of greater market
liquidity than actually exists, and may facilitate deceptive accounting (when the fictitious
trades are reported as real revenue). The energy derivatives market survived Enron’s fall,
but in mid-2002 appears to be shrinking, as major traders (and their customers and
shareholders) re-evaluate the risks of unregulated energy trading.
Internal Enron memoranda released in May 2002 suggest that Enron (and other
market participants) engaged in a variety of manipulative trading practices during the
California electricity crisis. For example, Enron was able to buy electricity at a fixed
price in California and sell it elsewhere at the higher market price, exacerbating electricity
shortages within California. The evidence to date does not indicate that energy
derivatives - as opposed to physical, spot-market trades – played a major role in these
manipulative strategies.
Even if derivatives trading was not a major cause, Enron’s failure 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 damage the dealer’s trading partners and
its lenders, and could conceivably set off widespread disruptions in financial and/or real
commodity markets. H.R. 3914 would amend 2000 legislation that exempted energy
derivatives from Commodity Futures Trading Commission (CFTC) jurisdiction. H.R.
4038 proposes to regulate the currently unregulated over-the-counter derivatives market
in a fashion similar to the current regulation of securities brokers and dealers by the SEC.
S. 1951 and Senate Amendment 2989 (to S. 517) would authorize the CFTC to require
disclosure of transaction data by traders in the over-the-counter energy derivatives market.
See also: CRS Report RS20560, Derivatives Regulation: Legislation in the 106th
Congress
, by Mark Jickling (7-778)