Those in the market will remember the downfall of Enron. It is one of the most impressive financial collapses in history and is still the subject of many stories. This year symbolises the 20th anniversary of this scandal marked by shady practices, deceits from its executives, inaccurate reportings and accounting malpractices. Let’s look back and examine how this downfall impacted the financial system and whether we learnt any lessons from this scandal.
What happened 20 years back?
Enron was founded in 1985 by Ken Lay and it soon grew to become one of the largest firms in the world. Its revenue surged from $5 billion a year to $200 billion and it had 20,000 employees globally. However, in 2001, it was found out that the firm had millions hidden debts and inflated profits and it filed for bankruptcy in December of the same year. The corporate darling, the ‘economy powerhouse… it was just all a mirage. As it turns out, its traders had been manipulating the electricity market and executives had been playing with their finances so much that when it crashed, it was forced to write off more than $1 billion of failed investments and disclose major losses in shareholder equity. As we say, “It was a total fiasco!”. Employees had just minutes to vacate the Enron building and they were seen carrying out cardboard boxes. Just like that, they had no job and their millions of dollars in retirement and pension funds were wiped out… All of this, during the festive month of December.
Repercussions on the American financial sector
Such a downfall has definitely had repercussions on the market, as was expected. First of all, the US stock market was stained with a huge black mark. At the time, most investors trusted the market. They could not even imagine that such a huge financial fraud could really happen when they purchased US listed stock. In fact, the US markets were seen as the gold standard when it came to transparency and compliance. Imagine what happens when you are at the top and suddenly, everyone discovers that you were a fraud. This was the sort of punch that the system received.
Considering how such a huge fraud went unnoticed, it became obvious that the sector needed to be strengthened. The government introduced several sets of strict regulations for firms. Auditors, accountants and senior executives… all have to adhere to huge requirements for record keeping and other activities. Let’s not forget: more criminal penalties for securities laws violations.
Moreover, everything was like a domino effect, which means more repercussions. All those rules and regulations meant that there was less choice for US stock investors and lower participation in stock ownership by individuals. People started thinking, “If a giant like Enron could collapse, what about us?”. A huge number of Americans stopped participating in the stock market and this still holds true even today. Those from lower classes are hesitant because they are afraid of losing their savings.
Additionally, following all the rules, regulations and bureaucratic form-filling that were involved, it became difficult for companies to IPO. It cost a lot money to go public and fewer companies were able to meet all the requirements needed. Now, firms wait until they are far larger before going public. Even today, fewer companies are listed. What does this mean? The public market has fewer investing opportunities, in comparison to private ones and small investors are excluded from participating and gaining.
What are some of the lessons learnt from this scandal?
Despite all the complaints about the regulations and new rules, one thing cannot be denied: the US financial market has learnt its lesson and it is now a safer environment. Investing in equities is now more transparent.
For instance, a year later, the Sarbanes-Oxley Act was introduced. This was described as “the most far-reaching reform of American business practices since the time of Franklin Delano Roosevelt”. What did it involve?
- The maximum prison term for fraud increased by four to reach 20 years.
- Chief executives and finance chiefs had to personally vouch for the truthfulness of financial statements and documents.
- The Public Company Accounting Oversight Board had to provide independent oversight of public accounting firms providing audit services.
- Standards for external auditor independence were established.
- Securities and Exchange Commission enjoyed more tools to try to restore confidence in the market.
In summary, its aim was to create a more controlled environment based on cross-checking, reconciliations, data verification and accountability. With these processes in place, it might be difficult to conduct fraud.
Additionally, since Enron’s board of directors was criticized and sanctioned, executives of other firms learnt their lessons. They became aware that the days during which everything was game to them were over and things had to be taken seriously now. The scandal, thus, acted as a form of governance lesson. Moreover, since then, there have been continuous calls for corporations to develop and commit to environmental, social and governance reforms that link corporate success to societal goods.
