Order Code RS21135
Updated January 30, 2003
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 corporate governance
and the stock market. 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 failed to warn investors of 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 summarizes
the Sarbanes-Oxley Act (P.L. 107-204), the major response by the 107th Congress to
Enron’s fall, and will be updated as the 108th Congress addresses related financial issues.
Other contributors to this report include William D. Jackson, Bob Lyke, Patrick
Purcell, and Gary Shorter.
Enron: What Went Wrong?
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.
Congressional Research Service ˜ The Library of Congress

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Until late 2001, nearly all observers – including Wall Street professional – regarded
this transformation as an outstanding success. Enron’s reported annual revenues grew
from under $10 billion in the early 1990s to $139 billion in 2001, placing it fifth 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 high-tech communications
businesses. Like many other firms, Enron saw an unlimited future in the Internet. During
the late 1990s, it purchased on-line marketers and service providers, constructed a fiber
optic communications network, and attempted to create a market for trading broadband
communications capacity. Enron entered these markets near the peak of the boom and
paid high prices, taking on a heavy debt load to finance its purchases. When the dot com
crash came in 2000, revenues from these investments dried up, but the debt remained.
Enron also recorded significant losses in certain foreign operations. The firm made
major investments in public utilities in India, South America, and the U.K., hoping to
profit in newly-deregulated markets. In these three cases, local politics blocked the sharp
price increases that Enron anticipated.
By contrast, Enron’s energy trading businesses appear to have made money, although
that trading was probably less extensive and profitable than the company claimed in its
financial reports. Energy trading, however, did not generate sufficient cash to allow
Enron to withstand major losses in its dot com and foreign portfolios. Once the Internet
bubble burst, Enron’s prospects were dire.
It is not unusual for businesses to fail after making bad or ill-timed investments.
What turned the Enron case into a major financial scandal was the company’s response
to its problems. Rather than disclose its true condition to public investors, as the law
requires, Enron falsified its accounts. It assigned business losses and near-worthless
assets to unconsolidated partnerships and “special purpose entities.” In other words, the
firm’s public accounting statements pretended that losses were occurring not to Enron,
but to the so-called Raptor entities, which were ostensibly independent firms that had
agreed to absorb Enron’s losses, but were in fact accounting contrivances created and
entirely controlled by Enron’s management. In addition, Enron appears to have disguised
bank loans 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, and corrected accounting statements were issued, over 80% of the profits
reported since 2000 vanished and Enron quickly collapsed. (For an Enron timeline, see
CRS Report RL31364.) The sudden collapse of such a large corporation, and the
accompanying losses of jobs, investor wealth, and market confidence, suggested that there
were serious flaws in 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 reference to CRS products that provide more detail.

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Auditing and Accounting Issues
Federal securities law requires that the accounting statements of publicly traded
corporations be certified by an independent auditor. Enron’s auditor, Arthur Andersen,
not only turned a blind eye to improper accounting practices, but was actively involved
in devising complex financial structures and transactions that facilitated deception.
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 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 too
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 (P.L. 107-204),
containing perhaps the most far-reaching amendments to the securities laws 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 other significant events that may require “real-time” disclosure;
! directs the SEC to adopt 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.

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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.
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. Many
employees’ retirement accounts were wiped out. 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 (107th Congress), which passed the House on April 11, 2002, would
have, among other things, required that account information be provided more often to
plan participants; improved access to investment planning advice; allowed the sale of
company stock contributed by employers after three years; and barred executives from
selling company stock while a plan is “locked down.” The latter provision was enacted
by the Sarbanes-Oxley Act. The 108th Congress is expected to revisit the issue.
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
In the wake of Enron and other scandals, corporate executives and boards of
directors were subject to critical scrutiny. At Enron, WorldCom, and elsewhere, top
management sold billions of dollars worth of company stock while serious financial
problems were being hidden from the public. Several provisions of Sarbanes-Oxley were
intended to remind CEOs of their duties to their firms and their public shareholders.
Stock trades by corporate insiders must be reported in a matter of hours, rather than weeks
or months. CEOs must personally certify the accuracy of their companies’ financial
statements. Criminal penalties for securities fraud offenses were increased.
The Sarbanes-Oxley Act also strengthened the oversight role of corporate boards.
Any nonaudit services provided by a firm’s outside auditor must be approved by the
board. The board’s audit committee, which must have a majority of independent directors
(who are not affiliated with management), will now be responsible for hiring, firing,
overseeing, and compensating the firm’s outside auditor. The audit committee must
include at least one director who is financially expert, able to evaluate significant
accounting issues and/or disagreements between management and auditors.

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Securities Analyst Issues
Securities analysts employed by investment banks provide research and make “buy,”
“sell,” or “hold” recommendations. These recommendations are widely circulated and
are relied upon by many public investors. 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.” Was analyst objectivity – towards Enron and other firms – compromised
by pressure to avoid alienating investment banking clients?
The Sarbanes-Oxley Act directs the SEC to establish rules addressing analysts’
conflicts of interest. In December 2002, 100 investment banks reached a settlement with
securities regulators and agreed to take steps to make their analysts independent of their
banking operations, and to pay fines totaling about $1 billion.
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, proposed just before Enron's collapse, and involving
further investments by 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 (P.L.107-204) requires the SEC to study the role of
investment banks in accounting deceptions and to report to Congress.
See also: CRS Report RS21188, Enron's Banking Relationships and Congressional
Repeal of Statutes Separating Bank Lending from Investment Banking, by William D.
Jackson.

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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 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 derivatives dealers have admitted to making
“wash trades,” which lack economic substance but give the appearance of greater market
volume than actually exists, and facilitate deceptive accounting (if the fictitious trades are
reported as real revenue). In 2002, energy derivatives trading diminished to a fraction of
pre-Enron levels, as major traders (and their customers and shareholders) re-evaluate the
risks and utility of unregulated energy trading. Several major dealers have withdrawn
from the market entirely.
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.
Legislation proposed, but not enacted, in the 107th Congress (H.R. 3914, H.R. 4038,
S. 1951, and S. 2724) would have (among other things) given the CFTC more authority
to pursue fraud (including wash transactions) in the OTC market, and to require disclosure
of certain trade data by dealers.
See also: CRS Report RS21401, Regulation of Energy Derivatives, by Mark Jickling.
CRS Report RS20560, Derivatives Regulation: Legislation in the 106th Congress, by
Mark Jickling.

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