Enron Scandal: “The Fall of a Wall Street Darling”

Enron Corporation was an American energy, commodities, and services company based
in Houston, Texas; founded in 1985 as a merger between Houston Natural Gas and InterNorth. The story
of Enron Corporation portrays a company that touched great horizons only to meet an untimely fall.
Enron’s collapse and the implications of its failure affected societal perception of financial markets, energy
industry, large corporations, and regulation. It was made apparently profitable through a constant push
for deregulation of the energy market. Enron reported high revenues but were mostly due to their
misrepresentation of financial documents and bad use of financial instruments.

The objectives of this case study are to illustrate the role financial instruments played in the downfall
of Enron. At the end, this case would take a dive into the resultant effects of Enron’s rise and fall while
recommending risk mitigation techniques that could have been applied to minimize Enron’s risk profile.

Role of Financial Instruments?

Enron acquired market power by building its physical capacity in each market and then leveraging that
investment through variable price structures for market participants, using financial derivatives as a way
of managing risks. They built assets such as power plant and then over valued its projected profit in its
books, despite not recording any revenues yet. Any loss accrued was transferred to corporations called
“Special-purpose entities (SPE)”, which allowed Enron to fraudulently manipulate it financial reports and
hide it liabilities while reporting huge profits. Enron’s model allowed for the accumulation of large debts
and rapid illusive growth while earning from wider derivative capacity such as profiting from trading
during the California energy crisis. These large profits in its trading activities was due to Enron being both
a dealer and a key market commodity participant.

Accordingly, Enron recorded heavy losses in its diversification particularly in cases that involve risk
management in its securities in ventures such as an electrical power plant in India and a water treatment
plant in the United Kingdom. Enron forced a deregulation of the market which generally led to lower
prices and increase in it supply. It traded in future markets, which allowed them hedge against adverse
price movements by entering into long-term fixed price arrangements with producers and used financial
derivatives, including swaps, options and forward. This unrealistic deregulation under the pressure of free
market advocacy allowed for deceptive accounting. The state of the financial market involving energy
futures allow Enron to estimate huge gains as it wanted without any close mark referencing.

Bottomline, Enron made some deceptive but permissible financial steps such as recording the full value
of each trade as revenue instead of the actual profit of each transaction and transferring of risk to SPEs.
However, the resultant effect in its repeated value innovation and deceptive financial practices created a
hazardous spiral in which the company was actually losing money; causing its bankruptcy.

Effects of Rise and fall?

Enron bankruptcy affected other market participants especially companies affiliated with Enron such
as the audit firm that collaborated with Enron to record misleading financial statements - Arthur
Andersen. The stock connected with their associates were instantly perceived as riskier which affected
investor’s confidence. This imposed the ideology that big organizations like Enron are able to mask
financial losses as seen in Enron’s SPEs, subsequently inflicting suffering on other large companies.

Also, unprecedented mistrust and lack of corporate hope ensued between large companies and their
employees. Enron employed approximately 29,000 staff and was a major electricity, natural gas,
communications and pulp and paper company, with acclaimed huge revenues. However, when Enron
declared bankruptcy, their employees were laid off and this caused increase in unemployment.

This event gave rise to other corporate scandals in the world, but influenced a widespread action of
companies cleansing their balance sheets. However, as a result of Enron’s demise, other players in the
market such as Dynergy and EI Paso had room to build their market shares and reduce the pressure off
the energy market.

Recommended risk mitigation techniques?

From the Enron scandal, it can be derived that stock prices are radically influenced by investors
perception of stock risk level. Thus, risk can be mitigated by equipping the investors with reliable tools
that could avail useful information to them when taking a decision. Organizations such as Enron and audit
firm - Arthur Andersen - should portray integrity by proper filing of balance sheets and adherence to
accounting ethics and standards.

In financial markets, there is a direct effect on returns that can be made by the speed and precision
with which information is delivered to market players. Efficient and effective Information aggregation and
coordination can be achieved through technology. It is also pertinent that market prices should be
determined by forces of supply and demand and not deregulation or monopolistic influence of a single
market entity. Thus, prices should be influenced by the general level of what buyers are willing to pay and
what sellers are willing to earn.

The nature of derivatives is that they are less transparent than traditional investment instruments.
They can be bundled into compilations of products which makes it difficult for holders to determine their
associated level of risk as in the case of Enron. To mitigate this risk and leverage on these derivatives, free
flow of market transaction should be allowed under proper regulation by an independent overseeing
source while carrying out appropriate risk assessment to influence best decision.

Conclusion
The case study on Enron’s profile has shown that wrong application of financial instruments, corporate
greed and the lack of proper market regulation caused Enron’s downfall. The case is perfect black swan
event for large corporations to learn. Hence, adopting proper risk assessment and measures could reduce
the market risk and companies falling in the future.

References
World Quant University (2019), WQU Financial Markets Module 1 [online], Accessed 6th October, 2019,
Available from the web: [https://masters.wqu.org/mod/folder/view.php?id=29821].
Investopedia (2019), Enron Scandal: The Fall of a Wall Street Darling [online], Accessed 6th October, 2019,
Available from the web: [https://www.investopedia.com/updates/enron-scandal-summary/#enrons-
energy-origins].
Moncarz, E., Moncarz,R., et al. (2016), The Rise and Collapse of Enron: Financial Innovation, Errors and
Lessons, Universidad Autónoma del Estado de México, ISSN 0186-102, ResearchGate, pp. 17-37.