Enron has come to symbolize the use of aggressive accounting techniques to mask excessive leverage and weak earnings. Some segments of financial markets have been volatile since Enron’s collapse—the largest bankruptcy in U.S. history—and the full extent of the losses suffered by investors and financial institutions will not be known until the company’s complex operations are unwound.

Abstract

Enron has come to symbolize the use of aggressive accounting techniques to mask excessive leverage and weak earnings. Some segments of financial markets have been volatile since Enron’s collapse—the largest bankruptcy in U.S. history—and the full extent of the losses suffered by investors and financial institutions will not be known until the company’s complex operations are unwound.

Enron has come to symbolize the use of aggressive accounting techniques to mask excessive leverage and weak earnings. Some segments of financial markets have been volatile since Enron’s collapse—the largest bankruptcy in U.S. history—and the full extent of the losses suffered by investors and financial institutions will not be known until the company’s complex operations are unwound.

Enron’s failure highlighted uncertainties about credi- risk transfer vehicles and underscored three broader issues:

Inadequate oversight of financial activities of nonfinancial corporations. Enron was the main dealer, market-maker, and liquidity provider in major segments of the over-the-counter energy derivatives markets and was also active in other derivatives markets (at the end of September 2001, its overall derivatives-trading liabilities stood at about $19 billion), yet these activities were essentially unregulated. It was not required to disclose information either about its risk exposures or about market prices or conditions, nor was it required to set aside prudential capital. Because its trading unit’s capital was not segregated from the parent company’s capital, banks lost confidence in the parent company and withdrew their credit lines, which, in turn, contributed to the collapse of the trading operation. Some observers have since called for revisions to the 2000 Commodity Futures Modernization Act, which exempts energy derivatives from regulatory oversight. Even without these exemptions, however, Enron’s activities in credit and other financial derivatives markets would have been essentially unregulated.

Ineffective private market discipline, disclosure, corporate governance, and auditing. Enron’s financial difficulties and vulnerabilities, including those associated with its extensive off-balance-sheet transactions, seemed to have gone undetected by analysts, shareholders, and creditors until it was on the brink of bankruptcy. In part, this may have been due to inadequate accounting rules and standards as well as to errors by its auditors, who failed to uncover related-party transactions and did not require Enron to properly consolidate its numerous, complex off-balance-sheet special-purpose vehicles in its financial statements. In October 2001, the correction of this and other errors resulted in a restatement of income by $600 million and a writedown of shareholder equity by $1.2 billion. Questions also arose about the auditor’s possible conflict of interest owing to its parent company’s extensive consulting business with Enron. Along with allegations that the auditor destroyed documents relevant to a Securities and Exchange Commission inquiry, these revelations led to calls for a close examination of auditing standards and practices.

Misallocation of retirement savings. More than 10,000 of Enron’s employees held most of their retirement savings in Enron stock, including Enron’s contributions (entirely in company stock that the company prohibited them from selling until age 50). In addition, the Enron shares in the pension fund were frozen for three weeks in October 2001 as the company switched plan administrators, during which time Enron stock fell by 35 percent. As a result of the lack of diversification and inflexibility, a large share of employee savings was wiped out in 2001, as Enron’s stock price plummeted from about $90 to less than $1. In early 2002, the U.S. authorities formed a working group to consider potential reforms to the Employee Retirement Income Security Act (ERISA) rules that govern private pension investments, and the U.S. Congress held hearings on how to address the gaps in ERISA that had permitted a high concentration of Enron stock in the company’s pension fund.