The Fall of Enron

From the start of the 1990s until year-end 1998, Enron's stock rose by 311 percent, only modestly higher than the rate of growth in the Standard & Poor's 500. But then the stock soared. It increased by 56 percent in 1999 and a further 87 percent in 2000, compared to a 20 percent increase and a 10 percent decline for the index during the same years. By December 31, 2000, Enron's stock was priced at $83.13, and its market capitalization exceeded $60 billion, 70 times earnings and six times book value, an indication of the stock market's high expectations about its future prospects. Enron was rated the most innovative large company in America in Fortune magazine's survey of Most Admired Companies. Yet within a year, Enron's image was in tatters and its stock price had plummeted nearly to zero. Exhibit 1 lists some of the critical events for Enron between August and December 2001-a saga of document shredding, restatements of earnings, regulatory investigations, a failed merger and the company filing for bankruptcy.

We will assess how governance and incentive problems contributed to Enron's rise and fall. A well-functioning capital market creates appropriate linkages of information, incentives and governance between managers and investors. This process is supposed to be carried out through a network of intermediaries that include professional investors such as banks, mutual funds, insurance and venture capital firms; information analyzers such as financial analysts and ratings agencies; assurance professionals such as external auditors; and internal governance agents such as corporate boards. These parties, who are themselves subject to incentive and governance problems, are regulated by a variety of institutions: the securities and Exchange Commission, bank regulators and private sector bodies such as the Financial Accounting Standards Board, the American Institute of Certified Public Accountants and stock exchanges.

Despite this elaborate corporate governance network, Enron was able to attract large sums of capital to fund a questionable business model, conceal its true performance through a series of accounting and financing maneuvers, and hype its stock to unsustainable levels. While Enron presents an extreme example, it is also a useful test case for potential weaknesses in the U.S. capital market system. We believe that the problems of governance and incentives that emerged at Enron can also...