Enron was born in 1985 from the merger of two companies specializing in the transportation of gas. At that time the energy sector deregulation including the gas market created a new competitive arena where companies fought aggressively for market shares. Then came along the need for trading and financial hedging tools.
Enron embarked on this new business in 1995 when they held a good market share, modernizing their methods in 1999 with the creation of EnronOnline, an electronic trading platform via the internet. Given its success, Enron extended its activity to the sale of electricity and also engaged in brokering many other products of all kinds: up to 1600 including metals, weather derivatives, communication products, wood, paper, water, etc …
In a few years, the company had become a major international energy trading player involved in a multitude of products. From a four billion turnover in 1989, they reached 100 billion in 2000, of which 90% came from their trading activities. Fabulous it seems, this is what we could tell by reading this story: deregulation may allow all this profit.
The CFTC indirectly supported this business by granting an exemption from monitoring and control of these activities, also known as a loophole, which is a flaw introduced in the legislation that promotes some market practices that could be abnormal or even fraudulent. The CFTC (U.S. regulator of the commodities markets) and the U.S. Congress under both Reagan and Clinton, were fervent adherents of the free markets with minimal government intervention. Hence they created such loopholes that experts called the London, Dubai or Enron loopholes.
In 1992, the president of the CFTC was Wendy Gramm, whom Ronald Reagan liked to call his favorite economist, took the decision to exempt Enron energy derivatives transactions from the CFTC supervision. Enron will greatly benefit from this situation, including by manipulating the markets until its final collapse.
The following year, Wendy Gramm resigns to join the Board of Directors of Enron. In 2000, a law supposed to regulate the markets, the Commodity Futures Modernization Act law, consecrated the Enron loophole: in the case of the energy and metals markets, the law exempted Enron from virtually all control by the CFTC of their OTC transactions (which do not pass through the regulated markets ), but also of their transactions on their electronic platform.
Even after the fraudulent bankruptcy of Enron, a number of deregulated electronic platforms were allowed to continue to operate until the bursting of the sub-prime bubble: there were up to eighteen in the United States, twelve of which were specialized in the energy market.
Enron’s profits were made possible by the combination of three mechanisms:
- use of sophisticated financial processes,
- manipulations to make unprofitable assets profitable,
- accounting concealment using offshore companies in banking and regulatory paradises as well as off-balance sheet operations.
In total Enron had over 3,000 subsidiaries in banking, tax, regulatory and legal havens to remove unprofitable activities from their consolidated balance sheet. JP Morgan was sentenced to pay a fine of $135 million for this fraud. JP Morgan was lending money to one of these offshore subsidiaries in order to buy a futures contract on gas or oil to be delivered several years later but paid immediately.
For its part, Enron passed control of an equivalent amount of oil or gas to another clandestine company managed in a secretive way by a subsidiary of JP Morgan. But no one delivered anything: it was in fact a disguised loan with no interest. Enron recorded the entire contracts with subsidiaries as a sale by artificially inflating its turnover. Between 1997 and 2001, seven such operations were found, involving a total of $2.6 billion. And there were many other similar frauds.
Why Enron executives engaged in such a large fraud? The most convincing answer is that they did it simply because they had the opportunity to do so, thanks to new mechanisms of the economy and financial markets that appeared at the time. Fraud was integrated as a means of management or as a permanent adjustment variable rather than at the margin.