Order Code RS21135
Updated September 18, 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. As firms become more transparent, the
ability of corporate insiders to pursue their own interests at the expense of rank-and-file
employees and public stockholders diminishes. Several aspects of this issue are briefly
sketched below, with references to CRS products that provide more detail.
Auditing and Accounting Issues
Federal securities law requires that the accounting statements of publicly traded
corporations be certified by an independent auditor. Enron’s outside audits were clearly
inadequate. When auditors saw accounting practices that would normally be regarded as
improper, they turned a blind eye. Moreover, Enron’s auditor was actively involved in
devising complex financial structures and transactions that facilitated deception. The
auditing firm, Arthur Andersen, has been convicted on criminal obstruction of justice
charges related to destruction of documents.
An auditor’s certification indicates that the financial statements under review have
been prepared in accordance with generally-accepted accounting principles (GAAP). In
Enron’s case, the question is not only whether GAAP were violated, but whether current
accounting standards 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 Securities ad Exchange
Commission (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.
In response to the auditing and accounting problems laid bare by Enron and other
corporate scandals, Congress enacted the Sarbanes-Oxley Act of 2002 (PL 107-204),

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containing perhaps the most far-reaching amendments to securities regulation since the
1930s. Very briefly, the Act does the following:
! Creates a new oversight board to regulate independent auditors of
publicly traded companies – a private sector entity operating under the
oversight of the Securities and Exchange Commission;
! raises standards of auditor independence by prohibiting auditors from
providing certain consulting services to their audit clients and requiring
preapproval by the client’s board of directors for other nonaudit services;
! requires top corporate management and audit committees to assume more
direct responsibility for the accuracy of financial statements;
! enhances disclosure requirements for certain transactions, such as stock
sales by corporate insiders, transactions with unconsolidated subsidiaries
and related parties, and other significant events that may require “real-
time” disclosure;
! provides for the adoption of rules to prevent conflicts of interest that
affect the objectivity of stock analysts;
! authorizes $776 million for the SEC in FY 2003 (versus $469 million in
the Administration’s budget request) and requires the SEC to review
corporate financial reports more frequently; and
! establishes and/or increases criminal penalties for a variety of offenses
related to securities fraud, including misleading an auditor, mail and wire
fraud, and destruction of records.
See also: CRS Report RL31554 , Corporate Accountability: Sarbanes-Oxley Act of 2002:
(P.L. 107-204), by Michael Seitzinger.
CRS Report RS21120, Auditing and its Regulators: Proposals for Reform After Enron,
by Bob Lyke.
For additional information contact Bob Lyke (7-7355) or Mark Jickling (7-7784).
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.

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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 the sale of company stock contributed by
employers after three years; and bar executives from selling company stock while a plan
is “locked down.” The latter provision was enacted by the Sarbanes-Oxley Act (PL 107-
204). Two Senate bills with generally similar provisions have been reported out of
committee: S. 1971 and S. 1992.
See also: CRS Report RL31507, Employer Stock in Retirement Plans: Investment Risk
and Retirement Security, by Patrick Purcell (7-7571).
CRS Report RL31551, Employer Stock in Pension Plans: Economic and Tax Issues, by
Jane Gravelle.
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, whose objectivity and
loyalty to shareholders are not supposed to be swayed by personal or business ties to
management. Should the way outside directors are selected be changed? 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.
The Sarbanes-Oxley Act (PL 107-204) requires prompt, electronic disclosure of
stock trades by corporate directors, senior executives, and other insiders. The Act also
gives the board’s audit committee direct responsibility for hiring, compensating, and
overseeing the company’s outside auditor. New rules proposed by the New York Stock
Exchange would require that a majority of directors be independent.
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 funds 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

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of the “dot com” stock crash. Is analyst objectivity compromised by pressure to avoid
alienating lucrative investment banking clients?
The Sarbanes-Oxley Act (PL 107-204) directs the SEC to establish rules regarding
conflicts of interest, disclosure of analysts’ (and their firms’) holdings in the stock and
other business relationships with the companies that the analysts cover.
See also: CRS Report RL31348, Enron and Stock Analyst Objectivity, by Gary
Shorter (7-7772).
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?
The Sarbanes-Oxley Act (PL107-204) requires the SEC to study the role of
investment banks in accounting deceptions and to report to Congress with
recommendations for possible amendments to securities laws.
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

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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 trading in derivatives is an extremely high-risk activity, no evidence
has yet emerged that indicates that speculative 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 and utility 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 S. 2724 would give the CFTC more authority to pursue fraud (including wash
transactions) and to require disclosure of transaction data by traders and certain over-the-
counter energy derivatives markets.
See also: CRS Report RS20560, Derivatives Regulation: Legislation in the 106th
Congress, by Mark Jickling (7-7784).

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