On December 2, 2001, the world woke up with shocking news: Enron filed for Chapter 11 protection in the U.S. Bankruptcy Court for the Southern District of New York. Thus began one of the most important corporate fraud scandals in the history of capitalism.
Enron’s fall not only meant the disappearing of the then seventh largest company (with assets estimated at $63 billion), but also the dissolution of Arthur Andersen, formerly one of the Big 5 audit and accounting firms.
The Enron case began a transformation of the corporate world. In several countries, new regulations and laws were enacted to improve the financial accuracy of listed companies. In particular, the Sarbanes-Oxley Act (SOX) was enacted in the United States, which established more drastic penalties for destroying, altering or manufacturing accounting records or for attempting to defraud shareholders.
SOX also imposed strict controls to keep audit firms neutral and independent from their clients.
In sum, Enron´s scandal led to a rethinking of the very concept of corporate governance and, at the heart of the business management debate, the importance of the proper management of fraud risks.
Two months from now, Jeffrey Skilling, the former CEO of Enron, will be released from prison after serving a 14-years sentence (reduced on appeal from 24 years). A federal jury found him guilty in May 2006 of conspiracy, insider trading, making false statements to auditors, and securities fraud.
Skilling had introduced an accounting methodology that was the basis of the overvaluation of Enron´s operations. The so-called “mark to market valuation” was a method used to value assets at their market price at each time of the accounting closing.
This approach opened the door to a net present valuation of future business flows that were in the process of being created but hadn’t yet materialized. It was essentially fictitious future income that was being counted as part of Enron’s current profits. And it was all done under the accommodating gaze of Arthur Andersen’s auditors.
Enron used complex transactions among company affiliates and other companies controlled by Enron officers to disguise losses as profits, and to obtain financing that was not accounted for as debt. Any financial structure based on phantom profits and unrecognized debt isn’t sustainable in the long run.
Nonetheless, Enron’s executives, with Jeffrey Skilling at the helm, continued the deception. It finally began to unravel when Bethany McLean wrote an article for Fortune magazine in March 2001 titled “Is Enron Overpriced?” Nine months later, more of twenty thousand employees, spread over 40 countries, had lost their jobs, and investors in the company were left with nothing.
What did the Enron debacle teach us? That regulators shouldn’t be complacent with companies that don’t disclose their financial information in a timely manner. That it’s important to keep the auditor independent from his client, and shouldn’t act as a consultant at the same time.
We learned that the prestige of a company is not enough to guarantee the veracity of its financial statements. That the gestation process of a billion dollar company requires consistency between the main financial indicators, and that when we see overnight corporate successes, we’re likely seeing a deception.
Finally, we learned to be more critical of the corporate world and less condescending to those who question an apparent success that emanates not from transparency but from a black box ruled over by secretive executives.
And yet, events following the Enron scandal showed that we didn’t learn enough. Lehman Brothers collapsed in 2008, followed by the subprime mortgage crisis. That same year Bernie Madoff’s fraud was revealed, as was Allen Stanford’s in 2009.
For me, the most important lesson from Enron that we forgot is that corporations need a lot of constant and consistent oversight and control. If things are left too loose, executives tend very quickly to mutate their business objectives into strategies that sometimes have little or nothing to do with legitimate business.
There was an Enron was because there was a Jeffrey Skilling. He knew how to find and exploit the gaps in the law. He co-opted the auditor and deceived the market, and became personally wealthy.
Enron teaches that the desire for profit sometimes has no limits. The ethical behavior of top management is not a condition that can be assumed as a fact that’s fulfilled at all times. Relying on the self-control of individuals doesn’t always work and shouldn’t be the basis of any organization’s governing structure.
The most recent studies on corporate fraud by Kroll are blunt: 10 percent of embezzlements last year were committed by top management, but the economic damage they cause accounted for 60 percent of the losses quantified by corporate fraud.
The accounting and financial practices of Jeffrey Skilling and his management team led to bankruptcy. Highly educated, skilled, and trained people, with deep proven talent, once led one of the most avant-garde companies in America and the world. Ultimately they were ruined by the human factor, and neither technology nor managerial innovations could save them.
And this is perhaps the biggest and yet the simplest lesson from Enron that we should never forget: Fraud happens when one of us succumbs to greed.
Arturo del Castillo, pictured above, is an Associate Managing Director of Kroll, where he directs the practice of Financial Investigation in Mexico. He has led fraud investigations for local and transnational companies, banks and financial institutions, oil and gas companies, manufacturing, entertainment, healthcare institutions and educational organizations. He can be reached here.