ACCOUNTING FRAUD CAUSED the seventhlargest corporation in United States to fall victim to white-collar crime. Its demise was due to accounting practices in violation of Securities and Exchange Commission (SEC) regulations. It is the classic case of the devil is in the details. From its founding in 1981 until the late 1990s, Enron was a dynamic, expanding energy corporation. The larger it grew, the more it diversified.
The accounting fraud at Enron was complex, but it is why it collapsed. Enron annual reports to shareholders stated very high earnings but kept nearly all its debt off the annual reports by stating in a footnote that a special purpose entity (SPE) covered the debts. The use of special purpose entities is a legitimate practice but there are federal regulations that were violated by Enron. A special purpose entity guarantees a debt for a price, which is its profit. First, though, it must have the assets to cover the debt. Second, SEC regulations requires it to be headed by a person not connected with a corporation which covers the debt. Third, investors in the special purpose entity must have sufficient capital at risk. None of these regulations were observed for the SPEs created by Enron officials.
Enron’s chief financial officer, Michael Fastow, created special purpose entities incorporated under the names LJM 1 and LJM 2 (his wife’s and children’s initials) among others directed by different Enron officials. These SPEs were just post office boxes and bank account numbers in the Cayman Islands. Fastow was president of both SPEs while at the same time an Enron executive in violation of SEC rules and Enron’s own internal code of ethics. LJM 1 and LJM 2 had no capital at risk. Their entire assets were Enron’s own money backed up by its stock. Fastow transferred hundreds of millions of dollars to LJM 1 and LJM 2 every year from 1997 to 2001. It was deposited in LJM accounts and returned to Enron minus the fee for covering Enron’s debt. The fee included Fastow’s salary as president of the SPEs and dividends for SPE shareholders. The amount returned to Enron was then listed in the revenue column on the annual report and debt in a similar amount erased from the liability column. As a result, Enron’s annual report showed very high income and virtually no debt, making it very attractive to investors.
The prudent decision would have been for Enron to use its high income to pay its debts. However, that would have left much less for shareholder dividends and would cause stock prices to advance at a slow rate based on the actual profitability of the corporation. Fastow and other Enron executives were major shareholders. Every year, 1997 to 2001, stock prices climbed and dividends were paid based on what appeared to be record financial performance.
In reality, the debts grew ever larger year to year until they reached $1.2 billion. At that point Enron declared it must revise its financial statements. As its stock value fell and the SPEs had no assets, bankruptcy was the unavoidable consequence.
On January 13, 2004, Fastow pleaded guilty to two felonies, becoming “the highest ranking officer at the company to admit to participating in crimes that contributed to Enron’s collapse into bankruptcy protection more than two years ago,” the New York Times reported. In his plea, Fastow admitted he had worked with other executive officers of Enron, including possibly Chief Executive Officer Ken Lay, “to disguise Enron’s deteriorating financial health, as well as engaging in a scheme to defraud Enron of millions of dollars for his own benefit.”
The business media reported prosecutors recommended that Fastow serve a 10-year sentence, the maximum under the two counts to which he pleaded guilty. The former chief financial officer faced an additional 96 counts, and settled related civil charges with the SEC. Fastow agreed to surrender more than $23 million in civil and criminal penalties. By July 2004, Lay was charged with 11 felonies, including conspiracy, making misleading statements, wire fraud, and bank fraud in a criminal indictment handed down by a grand jury. The SEC also filed a civil complaint against him.
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