9781315815350.ch11

This article was downloaded by: University College London
On: 24 Oct 2017
Access details: subscription number 11237
Publisher:Routledge
Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office: 5 Howick Place, London SW1P 1WG, UK
The Routledge International Handbook of the Crimes of the Powerful
Gregg Barak
Corporate-financial crime scandals
Publication details
https://www.routledgehandbooks.com/doi/10.4324/9781315815350.ch11
Brandon A. Sullivan
Published online on: 17 Jun 2015
How to cite :- Brandon A. Sullivan. 17 Jun 2015 ,Corporate-financial crime scandals from: The
Routledge International Handbook of the Crimes of the Powerful Routledge.
Accessed on: 24 Oct 2017
https://www.routledgehandbooks.com/doi/10.4324/9781315815350.ch11
PLEASE SCROLL DOWN FOR DOCUMENT
Full terms and conditions of use: https://www.routledgehandbooks.com/legal-notices/terms.
This Document PDF may be used for research, teaching and private study purposes. Any substantial or systematic reproductions,
re-distribution, re-selling, loan or sub-licensing, systematic supply or distribution in any form to anyone is expressly forbidden.
The publisher does not give any warranty express or implied or make any representation that the contents will be complete or
accurate or up to date. The publisher shall not be liable for an loss, actions, claims, proceedings, demand or costs or damages
whatsoever or howsoever caused arising directly or indirectly in connection with or arising out of the use of this material.
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
11
Corporate-financial
crime scandals
A comparative analysis of the collapses
of Insull and Enron
Brandon A. Sullivan
Introduction
This chapter examines two major historical corporate-financial crimes in the American energy
industry. Corporate-financial crime scandals have frequently occurred throughout history
(Markham, 2006), causing immeasurable harm to society while receiving inadequate attention
from academics, practitioners, and policy makers compared to traditional street crimes (Geis,
2007; Lynch et al., 2004; Simpson, 2002). Incentives in the securities market and corporate
cultures and structures encouraging organizational deviance create opportunities for corporatefinancial crimes, only some of which become widely known through highly publicized scandals.
Research into these crimes illuminates potential measures to prevent abuses undermining the
legitimacy of the financial and justice systems.
This chapter uses open source information from scholarly accounts and newspapers to present
a comparative historical case study of two corporate-financial crime scandals: Insull and Enron.
Insull involved the misuse of securities and complex corporate financing structures to carry
out a massive fraud with over US$750 million in losses. Insull developed an innovative strategy
for power distribution in the early 1900s, as a small Chicago utility company grew into one of
America’s largest utility conglomerates. Insull sold utility securities to many small investors who
believed these investments were sound, even though profits were heavily inflated and debt was
hidden through deceptive accounting. Enron used similar accounting strategies to mask fraud,
relying on mark-to-market (or fair value) accounting to speculatively inflate assets and remove
debt from balance sheets using shell corporations. Enron collapsed when the debt could no
longer be hidden, resulting in the largest corporate bankruptcy in American history at the time,
at over US$60 billion in losses. Enron was the first, and arguably most egregious, in a long list
of corporate-financial scandals from the 2000s. Both Insull and Enron are similarly large and
negatively impactful corporate-financial crimes in the energy industry separated by 70 years.
Both Enron and Insull exemplify what Black (2005) termed “control fraud,” where company
leaders use their businesses to defraud others while at the same time manipulating external and
internal controls to both carry out the crimes and prevent detection. Control frauds are highly
deceptive even to so-called experts and are touted as safe and profitable investments. Companies
172
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
Analysis of collapses of Insull and Enron
like Insull and Enron were at one time presented as models of positive business practices in corporate America, despite being largely insolvent for a number of years prior to their collapse. Similar
claims were made about other businesses that turned out to be control frauds deeply entrenched
in corporate-financial crime, including many Savings and Loans (S&Ls) in the 1980s and major
Wall Street firms in the late 2000s (Barak, 2012).
Control frauds, using accounting fraud as their primary weapon and shield, typically report
sensational profits, followed by catastrophic failure. These fictitious profits provide means for
sophisticated, fraudulent CEOs to use common corporate mechanisms such as stock bonuses
to convert firm assets to their personal benefits.
(Black, 2005, p. xiv)
These frauds are carried out by exploiting criminogenic environments lacking effective regulation and enforcement, and further tilt the scales in their favor through political contributions and
lobbying for deregulation (Black, 2005).
Despite the persistence of major corporate-financial scandals, no serious attempt has been
made to address root causes of corporate abuse on a policy level. Similar scandals like WorldCom, Tyco, Adelphia, Global Crossings, HealthSouth, and Fannie Mae undermine public confidence and trust in business and government, culminating from the near-endemic failure of
existing regulatory structures. While calls for reform often result from major corporate-financial
crimes, enacted policies are either watered down over time through corporate lobbying efforts
for deregulation or failures to address fundamental underlying problems. Many opportunities for
corporate-financial crimes could be limited by simple policies designed as checks in corporate
structures and eliminate potential conflicts of interest (Benson and Simpson, 2009). Further
research will aid in identifying policy alternatives and crime prevention mechanisms to reduce
harms caused by corporate-financial crime. This chapter emphasizes the failure of policies to prevent corporate-financial crime and the need for policy makers to address root causes of problems
instead of mitigating their symptoms.
This chapter offers an in-depth examination of the scandals themselves and the policy lessons
to be drawn from them. First, case histories of Insull and Enron are described in detail. Second,
specific aspects of both cases are reviewed, including the societal, control, and organizational
contexts. Third, policy implications are discussed, focusing particularly on unaddressed problem
areas.
Insull
The first case is the collapse of the Insull utility holding companies in the early 1930s. The concentration of corporate power in Insull holding companies created a house of cards dependent on
continuous speculative investment. Insull took out enormous debts and failed to recognize signs
of instability brought on by worsening economic conditions. The Insull scandal was a major contributing factor to the 1930s Securities Acts and other New Deal regulations aimed at addressing
conflicts of interest and providing stability in banking, securities, and utilities industries.
In the early 1900s, only the wealthy could afford electricity. Power companies had individual
lines, central power stations were rare, and small generators powered most buildings instead of
central stations (Cudahy and Henderson, 2005). More than 30 power companies in Chicago
provided electricity for different buildings and streets from individual generators (McDonald,
1962). Streetcar companies would use their generators during morning and evening commutes
when transportation levels were greatest and street-lighting companies only used their generators
173
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
B.A. Sullivan
at night. This began to change in 1892 when Thomas Edison’s former personal secretary, Samuel
Insull, left the newly created General Electric to become president of a small, Chicago-based
power company called Chicago Edison Company and secured power within the company by
purchasing a substantial amount of stock (McDonald, 1962; Munson, 2005). Insull had vast
knowledge of both the financial and technological aspects of the electricity industry, providing a
competitive advantage against other Chicago utilities (Cudahy and Henderson, 2005).
Insull believed the existing power supply structure was an incredibly inefficient and wasteful
system because it kept prices too high for the average American to afford electricity (Munson,
2005). Chicago Edison constructed the Harrison Street Station, the largest centralized power
station in the world at the time, to provide cheaper and more efficient electricity (Cudahy and
Henderson, 2005). Insull established an anti-competition philosophy within his companies and
sought to dominate the utilities industry. This attitude permeated the entire organizational culture of Chicago Edison, as salesmen were pushed to undercut prices of smaller companies. Insull
blocked competition by establishing power facilities restricting other companies from supplying
their customers. Insull also bribed politicians and streetcar companies to purchase power from
Chicago Edison, becoming the sole issuer of electricity for several government-run transportation systems (Cudahy and Henderson, 2005).
Insull’s efforts paid off, as the companies grew dramatically throughout the early 1900s.
Achievements included: customer growth, from 5000 in 1892 to 200,000 in 1913 (Munson, 2005);
increased electricity sales 12 per cent annually from 1900 to 1920 (Munson, 2005); increased
construction projects, from $500 million in 1902 to $2 billion in 1912 (Munson, 2005); decreased
consumer costs, from 20 cents per kilowatt-hour in 1897 to 5 cents in 1906, then 2.5 cents in
1909 (McDonald, 1962); expanded to 400 communities in 13 states (Cudahy and Henderson,
2005); developed over 30 state regulatory commissions with centralized, monopoly control over
electricity distribution (Munson, 2005); ownership of Insull securities by thousands of individual
investors, with sales increasing from 6000 in 1921 to over one million by 1930 (Cudahy and
Henderson, 2005) under the perception of Insull securities as a safe investment, as the 1929 stock
market crash did not immediately impact utility holding companies (Munson, 2005).
Insull’s increasingly complex utility company structure is characteristic of control fraud,
requiring a tremendous amount of constantly flowing capital to be sustained. Middle West Utilities was set up as a utility holding company to control the Insull expansion. Insull convinced
many investors of middle to lower socioeconomic status of the security of electricity investments
(Munson, 2005), highlighting the relative safety of investing in utilities with marking tactics
such as the phrase: “if the light shines, you know your money is safe” (Cudahy and Henderson,
2005, p. 52). Guaranteed dividends encouraged wide investment, providing funding for Insull to
acquire numerous other electric companies (Bonbright, 1972; Munson, 2005).
The seeds of Insull’s downfall were planted when a private investor named Cyrus Eaton bought
large amounts of Middle West securities. Fearful of losing control, Insull Utility Investments
(IUI) was created to protect against an outside takeover (Munson, 2005), creating a new layer of
holding companies on top of the pyramid of existing Insull-controlled companies (Cudahy and
Henderson, 2005). Corporation Securities of Chicago (Corp) was also created as another holding
company to purchase shares of stock in IUI. Each holding company owned stock in the other,
with Insull managing both companies. However, the actual number of power-generating utility
companies in the conglomerate was decreasing while utility holding companies were growing
rapidly. After the stock market crash, utility companies maintained strong financial grounding
due to the consistent demand for electric power, but holding companies themselves were not
as stable. Insull’s business practices did not change to reflect the plummeting financial market,
although dividends began to be issued in stock rather than cash to retain enough capital to
174
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
Analysis of collapses of Insull and Enron
continue expansion (Munson, 2005). Insull reassured investors and company employees that the
companies and investments were sound. He then took out $20 million in additional loans from
J.P. Morgan to purchase $56 million in IUI securities owned by Eaton, offering his companies as
collateral (Cudahy and Henderson, 2005; Munson, 2005).
When Insull could no longer pay interest on the loans, New York bankers appointed accounting firm Arthur Andersen to audit the holding companies. Up until that point, Insull was able
to manipulate auditors to obtain favorable reviews, but this leverage could not be exerted over
independent auditor Arthur Andersen. Andersen accountants re-examined Middle West’s bookkeeping and discovered the company was insolvent, having been profitless for years and funded
entirely by IUI and Corp investors (Cudahy and Henderson, 2005). IUI and Corp were declared
worthless stocks (NYT, 1934c). When the worthless value of the utility companies was publicized, investors rapidly attempted to sell their securities and Samuel Insull was forced to resign
from leadership positions in his conglomerate of utilities and holding companies. Insull investments dropped over US$150 million in value in one week in September 1931, with share prices
falling from US$570 to US$1.25. Middle- and lower-class shareholders lost their entire investment at a combined total of over US$750 million (Wasik, 2006).
The newly created Securities and Exchange Commission (SEC) subsequently opened an
investigation into the holding companies, citing accounting irregularities, asset value inflation,
and securities misrepresentation (Munson, 2005). Samuel Insull left the United States for Europe
as criminal indictments were issued against him and other executives for embezzlement, fraud,
and larceny. He maintained innocence of these charges of engaging in control fraud, admitting
that mistakes were made in misjudging the financial condition of companies but investors were
not purposely defrauded (NYT, 1934b). In a subsequent criminal trial, Insull and his 16 codefendants were acquitted of all charges (NYT, 1934a). Both federal and state prosecutors again
unsuccessfully attempted to convict Insull on related charges in the months to follow but Insull
escaped criminal sanctions (Cudahy and Henderson, 2005).
New Deal legislation recognized that control frauds like Insull had swindled the American
people and rested on the assumption that “big business” could not be regulated effectively by the
states alone (Cudahy and Henderson, 2005). Reforms included federal regulation of securities
(Securities Act of 1933 and Securities Exchange Act of 1934) and utilities (Public Utility Holding Company Act of 1935 and Federal Power Act of 1935). This legislation contributed to the
long-term stability, consistency, and reliability in energy distribution as well regulated utilities
retaining monopolies over defined geographic locations. Although not without problems, this
model became the standard for generations until renewed criticisms of regulation in the 1970s,
eventually contributing to the development and downfall of Enron.
Enron
Enron was once well respected, having been named the most innovative company in America
six years in a row by Fortune, but this reputation turned to one of greed and fraud after Enron
collapsed amidst accusations of securities fraud and inside trading. Enron involved similar complicated financial structures as Insull, resorting to speculative risk-taking to inflate stock values
and cash in stock options to the personal benefit of the company’s executives. Fraud began when
executives became primarily concerned with increasing stock prices to attract investors, relying
heavily on control fraud and accounting manipulations instead of furthering legitimate business
ventures. Enron illustrates the dangers of both organizational deviance through deception and
manipulation of financial markets, and the increasing complexity and lack of transparency of
corporate finance. Along with the collapse of WorldCom, Enron was responsible for the passage
175
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
B.A. Sullivan
of corporate governance reforms in the Sarbanes-Oxley Act of 2002, which aimed to increase
accountability for executives, accountants, and securities analysts.
Enron emerged in 1985 under the direction of Chairman and CEO Kenneth Lay, becoming
the first interconnected natural gas pipeline in the United States (Healy and Palepu, 2003). Lay
sought to expand Enron’s operations by changing the energy supply structure through deregulating natural gas markets and allowing greater flexibility in pricing and partnerships. Enron took
advantage of the newly deregulated energy market by trading financial contracts de-emphasizing
direct control of physical assets (Van Niel, 2009). Under the leadership of Chief Operating
Officer (COO) Jeffrey Skilling, Enron began to purchase other energy companies, pipelines,
broadband fiber optic cable lines, and electricity plants to control major sectors of the energy
distribution chain (Healy and Palepu, 2003; Van Niel, 2009). This strategy of increasing control
over distribution and trading energy allowed Enron to legally siphon off and store energy to sell
long-term contracts at higher rates (Skeel, 2005).
The complexity of Enron’s business dealings revolved around control fraud, consisting of a
maze of accounting strategies disguising the company’s true financial condition. Two techniques
critical to the fraud were mark-to-market accounting and “special purpose entities” (SPEs).
Mark-to-market allows transactions to be recorded based on projected future earnings instead
of actual, immediate earnings. Instead of listing actual prices of buying and selling natural gas,
Enron listed projected profits on various long-term contracts made with third parties, recording
profits even if the project actually lost money (Healy and Palepu, 2003). For example, Enron
lost over US$1 billion building a power plant in India whose generated energy was unaffordable
to the Indian citizens but still recorded US$20 million in earnings (McLean and Elkind, 2003).
With Enron’s losses being portrayed as profits, Enron Chief Financial Officer (CFO) Andrew
Fastow heavily utilized over 300 SPEs that functioned as shell corporations to remove debts from
Enron’s balance sheet (Healy and Palepu, 2003; Van Niel, 2009). As both the CFO of Enron
and the manager of the SPEs, Fastow had insider knowledge of the company’s financial dealings,
allowing him to personally profit from the transactions. Enron assumed most of the risk from the
SPE projects, but the SPEs hid the growing debt and project losses, creating the artificial impression that the company was fiscally sound.
Another common pattern of control fraud involved an executive compensation structure
allowing company assets to be converted into personal profits, as many top executives were paid
in stock options instead of cash (Coffee, 2002). Initially intended to attract top talent and align the
interests of shareholders and managers, stock options created an incentive for executives to artificially inflate stock prices and sell back the stock at the higher price to make multi-million dollar
personal profits (Healy and Palepu, 2003; McLean and Elkind, 2003). Enron’s stock prices increased
from US$19 per share in 1997 to US$40 in 1999 and then to US$90 in 2000 (Windsor, 2009).
The true value of the stock options was hidden from investors because they were not claimed as
expenses on financial statements, further disguising the heavy debt load (Van Niel, 2009). This
focus on short-term profits instead of long-term stability contributed heavily to Enron’s collapse.
By 2001, Enron’s true fiscal condition could not be hidden. As new projects failed, Enron
executives could no longer continue making the company appear profitable. On August 14,
2001, Skilling announced his resignation as CEO and President of Enron, having taken over the
position from Lay just six months earlier (Oppel and Berenson, 2001). Lay resumed control of
Enron and cited personal reasons for Skilling’s resignation (Windsor, 2009). Lay tried to reassure
investors and employees by stating that the company’s condition remained healthy. At the same
time, however, Enron executives (including Lay and Skilling) cashed their stock options and made
millions of dollars while employees of Enron-owned businesses were locked out of their accounts,
and forced to watch their life savings completely dissipate (McLean and Elkind, 2003).
176
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
Analysis of collapses of Insull and Enron
In late 2001, Enron restated financial earnings from overvalued profit projections for several
prior years to reflect numerous profitless projects. Some US$618 million in losses were rereported along with US$600 million in decreased profits and US$3 billion in newly disclosed
debt (Windsor, 2009). By November 29, 2001, credit rating agencies reduced the value of Enron
securities to junk status (NYT, 2001). On December 2, 2001, Enron filed for bankruptcy and
tens of thousands of employees lost their jobs. Investors, creditors, shareholders, and employees of
Enron were severely harmed by the collapse, particularly those investing their retirement savings
in Enron (Oppel and Sorkin, 2001; Windsor, 2009).
Many Enron executives were indicted and convicted. Skilling was sentenced to 24.3 years in
prison and Fastow to six years, while Lay’s sentence was commuted when he passed away (NYT,
2006). Accounting firm Arthur Andersen was found guilty of obstruction of justice for shredding thousands of Enron-related documents in the wake of the collapse, ultimately leading to the
90-year-old firm’s collapse.
Discussion
The corporate-financial crimes of Insull and Enron are not anomalies occurring in a vacuum,
but result from complex interactions among social institutions, corporations, and individuals.
While the factors discussed later contribute to environments of organizational deviance, they
do not explain how or why these contexts and organizational characteristics come together and
eventually erupt into corporate-financial securities frauds. Without considering the historical
context of the criminogenic environment produced through structural relations within a developing system of public–private finance, these corporate-financial scandals are often portrayed as
mechanistic, knee-jerk or determinist reactions or innovations by “collective action” to facilitate
the survival of these organizations by way of fraudulence (Barak, 2012). These crimes are distinctive (although massive in size, scope, and impact) illustrations of control fraud carried out by
leaders of firms to amass large amounts of unwarranted power and wealth. In order to provide
explanations for these forms of organizational deviance, analyses must incorporate theories of
fraud stemming from a political economy of crime. Control fraud theory provides the theoretical basis for understanding how these crimes develop in criminogenic environments to produce
corporate-financial fraud.
Several interrelated contexts provide the basis for understanding the corporate-financial
crimes of Insull and Enron, including the societal, control, and organizational contexts. This
structural analysis focuses on the political-economic environment (societal context), the lack of
control mechanisms to prevent these control frauds from developing (control context), and the
organizational processes and structure of interactions shaping organizational deviance (organizational context).
Societal context
The societal context focuses on the political-economic environment surrounding the Insull and
Enron scandals, including stock market speculation, increasingly concentrated corporate power,
political influences on regulatory oversight, and the introduction of new players in markets
lacking appropriate regulation. Rampant stock market speculation in the 1920s was a breeding ground for fraud. Constant expansion of utilities pushed prices down for many, but this
rapid expansion was built on a house of cards. While Insull weathered the early effects of the
Great Depression, company executives massively inflated stock values and took on excessive
debt before finally collapsing in 1932. Enron followed similar patterns of speculative stock price
177
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
B.A. Sullivan
manipulation, as fraudulent reporting and accounting tricks replaced traditional, disciplined business and accounting practices in many well-known and powerful corporations (Cunningham,
2003), fueling economic expansion but hiding the true value of company securities (Rockness
and Rockness, 2005).
For both Enron and Insull, political and legislative actions encouraged illegal and unethical
behavior through either corruption or negligent inaction. In addition to a history of bribing
public officials to gain exclusive contracts and a large contribution to presidential candidate (and
former head of Illinois Commerce Commission) Frank Smith harming his reputation, Insull
continued expanding operations despite an ailing economy, in large part through the encouragement of the Hoover administration and state politicians. In the wake of the 1929 stock market
crash, politicians and industry leaders worked together to reassure the public of the soundness
of the financial system by continuing to spend, maintain employment counts, and promote the
soundness of the failing market (Wasik, 2006). Insull continued to acquire debt, despite the
deepening depression, and eventually overextended, leading to the demise of the unstable Insull
holding company structure.
After the 1970s changes in political finance laws, corporations and their employees were
permitted to contribute to campaigns and create political action committees (PACs), increasing
corporate influence over policy making (Prechel and Morris, 2010). Corporate lobbyists for
Enron in the late 1990s became large political contributors to candidates supportive of deregulation and limits on existing regulatory powers (O’Brien, 2005). Securities issuers influenced policy
makers to limit liabilities for accountants for fraud and prevented attempts to restrict non-audit
(consulting) services provided by firms simultaneously serving as auditors (Coffee, 2002; Gerding,
2006; Rockness and Rockness, 2005).
An attitude of non-intervention in business pervaded both Insull and Enron as new market opportunities opened up with little transparency and oversight. Political-economic changes
increasingly concentrated power and wealth in a few elite corporations at the expense of smaller,
more dispersed companies. Insull took advantage of the lack of centralized power utilities to
monopolize power generation and distribution under holding companies, as once independently
operated utilities came under the control of a small number of owners like Insull. Enron’s promotion of deregulation enhanced their power in energy trading to increase revenue and acquire
many smaller companies. Enron executives knew that by advocating ambiguous regulatory
changes and expanding to unknown markets (broadband, energy, and weather trading), they
could vastly expand their market share and control multiple sectors of the energy industry. These
unprofitable trading schemes covered up by accounting manipulations allowed Enron to appear
highly successful for many years, but ultimately led to the company’s downfall.
The laissez-faire attitude toward regulation dominated the societal context of Insull and
Enron, with proponents arguing that businesses are best left to be self-regulated, with direct
government oversight kept to a minimum. The central goal of the Insull utility companies was
to create a private monopoly over power distribution. Insull took a different approach than other,
similar corporate-financial frauds by advocating for the regulation of utility companies to counteract pushes for public ownership. To Insull, private monopolies would keep corrupt politics out
of private business, drive down consumer prices, and increase service quality (Anderson, 1981;
McDonald, 1962; Munson, 2005). In one respect, this was a creative adaptation of the laissez-faire
economic approach, as Insull recognized the greater ease of manipulating state regulators than
unpredictable scrutiny from hundreds of municipal governments. Insull became a chief advocate
of state regulation to allow legal monopoly over much of the utilities industry (Wasik, 2006).
State regulators in turn advanced utilities by negotiating price reductions, effectively functioning
as an industry advocate.
178
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
Analysis of collapses of Insull and Enron
Since the reforms of the Insull scandal, energy distribution had been heavily regulated. These
regulations began to erode with the Natural Gas Policy Act of 1978, which allowed consumers to
choose from among multiple suppliers instead of locking them into regional distributor contracts
(Van Niel, 2009). The Energy Power Act of 1992 brought about similar structural changes in
electricity distribution, as third-party entities were permitted to purchase and redistribute blocks
of wholesale electricity from power generators and to local companies (Van Niel, 2009). Brokers
became middlemen negotiating deals between consumers and suppliers, with the goal of eliminating restrictions on energy movement between regions to create more efficient distribution
and drive down consumer costs. However, this changing political-economic environment was
ripe for control fraud, as many new third-party brokers were opportunists seeking easy money
in the newly deregulated market.
The political-economic environment of the 1990s catered to the interests of large corporations and securities issuers at the expense of individual investors, and ultimately the integrity of
the financial system as a whole. The prevailing wisdom, which persists in the present day, is for
free market forces to operate without (or with minimal) government restrictions. Enron not only
benefited from deregulation, but Enron executives Ken Lay and Jeff Skilling were chief proponents of deregulation. This contributed to a regulatory infrastructure with limited capacity to
prevent the worst harms from the Insull and Enron scandals.
Control context
The control context focuses on social control mechanisms, including formal government agencies and non-governmental and informal control systems, such as industry organizations, stock
exchanges, and self-imposed oversight entities. The governmental authority to govern sales of
securities was not in place until after Insull’s collapse. There was no oversight mechanism for
reining in potential control frauds until they were already on the verge of collapse. Once the
SEC was in place in 1934, an investigation and subsequent charges were issued against key Insull
executives, although far too late to prevent massive investor losses. By the time of Enron, a regulatory structure overseeing securities markets had been in place for nearly 70 years. However,
neither government regulators (SEC) nor informal control agents (ratings agencies, auditors,
analysts, etc.) were able to uncover the fraud until Enron was already on a highly publicized
downward spiral. This is typical of control frauds, where effective market discipline is not
adhered to, but instead collective willful ignorance is exercised, with non-existent or suspicious
business practices and non-transparent financial transactions ignored or accepted as signs of
healthy company growth.
Regulators consistently lacked the proper resources (and political will) to identify the Enron
fraud until the company was on the verge of collapse (Skeel, 2005). The SEC ultimately failed
to closely audit Enron’s financial transactions and accounting irregularities (Van Niel, 2009). In
fact, the SEC had earlier examined Enron’s use of mark-to-market accounting rules and legitimized these subjective and speculative profit estimations (McLean and Elkind, 2003). At the same
time, the SEC reduced observations of major accounting firms, further compounding fraudulent
opportunities. However, these failures were due in part to a political-economic climate limiting the ability of the SEC to effectively enforce securities laws (O’Brien, 2005). During periods
of economic growth, regulators and policy makers face pressures to avoid restricting economic
opportunities and corporate profits (Gerding, 2006). Regulators are often marginalized by these
political constraints hindering the investigation and sanctioning of corporate-financial fraud.
Non-governmental control mechanisms were non-existent or ineffective. Key evaluation and
oversight entities that are supposed to be independent, objective evaluators of financial and
179
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
B.A. Sullivan
trading practices, ultimately helped to create the Enron illusion. Their failure to appropriately
evaluate Enron’s condition effectively condoned the fraudulent accounting methods used to
manipulate stock values. Investors, analysts, rating agencies, and creditors generally did not ask
appropriate questions about how Enron made massive profits, instead seeming content to blindly
accept Enron as a successful company. Enron failed to produce basic accounting products such
as balance sheets, income statements, and cash flow statements. Financial analysts responsible for
overseeing the soundness of the securities market were employed by investment banks doing
business with Enron and issued inaccurate stock value assessments due in large part to conflicts
of interest in funding stock research, contributing to Enron’s deception (Aronson, 2002). Even
after accounting irregularities became public in October 2001, Lehman Brothers and Merrill
Lynch both rated Enron stock with strong buy recommendations. Enron paid more than US$125
million in fees to these and other investment banks from 1998 to 2000, creating a conflict of
interest undermining the objectivity of their evaluations (Healy and Palepu, 2003; McLean and
Elkind, 2003).
Others conflicts of interest and/or acts of collusion existed among Enron and Insull auditors. Insull manipulated self-appointed auditors to approve fraudulent accounting records until
J.P. Morgan appointed Arthur Andersen as auditor, which ultimately uncovered the control
fraud. Ironically, Arthur Andersen was hired by Enron nearly seven decades later and was instrumental in covering up their accounting fraud, ultimately leading to Andersen’s demise. Andersen
was paid US$52 million, half for auditing and half for consulting (Van Niel, 2009), which in part
influenced them not to report Enron’s true financial condition for fear of losing business. Had
Andersen brought this to light, the firm would likely have been fired as auditor, but brought
much-needed public scrutiny and SEC investigations. Arthur Andersen instead relinquished its
once stellar reputation for honesty and integrity for short-term profits.
Organizational context
The societal and control contexts alone do not explain how these frauds ultimately developed,
but rather form the criminogenic environment essential for the Enron and Insull control frauds
to flourish. The organizational context addresses specific behaviors of both companies and their
executives in executing control fraud. Central to these frauds is organizational deviance, where
collective actions are taken to carry out corporate-financial crime, regardless of whether or not
these actions are illegal at the time.
Excessive risk-taking and speculation included manipulation, deception, omission, and destruction of evidence to cover up wrongdoing. More money could be made through these illegitimate
means than legitimate business operations, as fraudulent behavior became normalized within each
company. Both Insull and Enron are classic examples of stock manipulation, as stock values were
artificially inflated through overly complex and fraudulent accounting practices. Stock prices of
Insull’s IUI and Corp were highly priced even though the companies held little capital and few
assets aside from one another’s stock. Enron, on the other hand, used SPEs as shell corporations to
hide debt and make the company appear profitable when it was actually losing money. Since much
of Enron executive pay was issued in stock options, there was an incentive to increase the stock
price and then sell the stock back before the price dropped, which is what many key executives
did prior to the collapse.
Unchecked fraud resulted in the concentration of vast amounts of artificial wealth, inflating
bubbles that would eventually destroy both companies. Both Insull and Enron increasingly relied
on speculative securities trading to increase their stock value, often resorting to fraudulent tactics to meet unrealistic Wall Street projections. Organizational cultures in both companies were
180
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
Analysis of collapses of Insull and Enron
overtaken by social pressures to maintain consistent and increasing profits, leading to the inflation of stock values to give the appearance of healthy fiscal performance and allow executives to
cash their stock options, taking millions of dollars out of the company. Insull executives profited
enormously from the fraud, although they lost their money when the companies collapsed, while
Enron executives took massive amounts of money out of the company for personal gain. While
speculation and risk-taking are not inherently dangerous and can be essential for advancing
legitimate innovations, companies not producing real goods or services and taking excessive risk
for the sake of money alone pose a hazard to the financial system.
Complex finance made understanding what was occurring particularly difficult, offering
a partial explanation for why the fraud was not detected until after the scandal had come to
public light. The complexity of the financial structures was overwhelming to the point that not
even those inside the companies fully understood them. The Insull financial holding company
structure was so complicated that even Samuel Insull himself did not entirely understand how
it worked. Enron executives knew that as long as new projects were created to show profits on
balance sheets, numbers would appear favorable and investors would trust their money with the
company. The iconic status of Insull and Enron allowed them to raise capital without having to
explain their financial structures. Although enough information (or perhaps, more appropriately,
the lack of transparent records) was available to the public for a rational investor to sense something suspicious (Cudahy and Henderson, 2005), few were able to dissociate themselves enough
to question the fiscal “black boxes” until long after the scandals became public.
The chaos ensuing from the Enron and Insull collapses is characteristic of other cases of
corporate-financial crime, with the political-economic environment, lack of effective controls,
and profit-driven organizational deviance. These corporate-financial crimes had been ongoing
for many years, but came to light relatively quickly as both companies went rapidly downhill in
highly publicized scandals revealing the severe consequences of the control frauds. The Insull and
Enron collapses brought severe economic and social hardships for ordinary investors, many of
whom were middle- and lower-class Americans. When Enron was finally forced into bankruptcy, tens of thousands of employees and investors lost their jobs and life savings. Other social
costs included loss of confidence in corporations and securities, psychological distress, and criminal justice system efforts to sort through the resulting chaos.
Implications
This comparative case study identified commonalities and differences between the Insull and
Enron scandals, including multiple factors weakening efforts to address corporate-financial crime.
Laws changed after Insull to criminalize behaviors not illegal at the time were the foundation for
later criminal indictments of Enron executives, including the 1930s Securities Acts that created
the SEC. After the collapse of Enron (and WorldCom several months later), confidence in the
stock market eroded and the Sarbanes-Oxley Act of 2002 was quickly passed, aimed retroactively
at addressing Enron and similar corporate misconduct (Skeel, 2005). President George W. Bush
upon signing the Sarbanes-Oxley Act called it the “most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt” (Bumiller, 2002). While designed to
increase the accountability of corporate executives, accountants, and securities analysts, many key
elements precipitating control fraud were left largely unaddressed.
Perhaps the most striking example of the failure to learn from history is illustrated in the
differences between the handling of the aftermath of Enron and Insull and large-scale corporatefinancial frauds in the late 2000s. While Enron and other control frauds at the time were followed
by attempts to address the frauds through criminal prosecutions, elite financial fraud ceased to be
181
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
B.A. Sullivan
taken as seriously only a few short years later. Once the criminal prosecutions of the early 2000s
had concluded, business as usual returned with even fewer resources for investigating corporatefinancial crime. After 9/11, 500 of the 2300 FBI white-collar crime agents were transferred to
national security, representing a lack of commitment to addressing financial fraud as priorities
shifted toward counter-terrorism (Black, 2013).
While control efforts were seriously lacking for Enron, subsequent developments from the
subprime mortgage crisis proved to be even more widespread and damaging. In lieu of criminal
prosecution, deferred prosecution agreements (DPA) became even more prominent, as virtually
no companies are now indicted without a DPA already in place (Spivack and Raman, 2008). This
indicates a shift in focus away from criminal liability and toward cooperation with corporate lawbreakers with the goal of achieving the desired behavioral changes without the risk of negatively
impacting the company. Failures of control mechanisms demonstrate that laws on the books are
not sufficient to address major corporate-financial crime. Regulators and prosecutors with sufficient resources, motivation, and political will to tackle the problem are essential.
The subprime mortgage crisis and subsequent bail-out of major financial institutions exemplified many persistent problems posed by corporate-financial crime. Regardless of the fact that
these frauds largely contributed to the near collapse of the global economy, no serious efforts have
been made to prosecute the fraud contributing directly to the 2008 financial crisis, with politicaleconomic considerations directly preventing the administration of justice in cases of fraud perpetrated by elite banks (Barak, 2012; Pontell et al., 2014). Department of Justice (DOJ) Assistant
Attorney General Lanny Breuer argued that he could not bring criminal charges due to the lack
of evidence to achieve a conviction and worried openly about the potential economic impact of
prosecuting large financial institutions (PBS, 2013). Although he later backtracked, arguing that
the DOJ aggressively pursues corporate-financial crime, Attorney General Eric Holder remarked
before the Senate Judiciary Committee:
I am concerned that the size of some of these institutions becomes so large that it does
become difficult for us to prosecute them when we are hit with indications that if we do
prosecute – if you do bring a criminal charge – it will have a negative impact on the national
economy, perhaps world economy. . . . I think it has an inhibiting impact on our ability to
bring resolutions that I think would be more appropriate.
(C-SPAN, 2013)
The idea is that large banks are essential to the economy, and with the economy being stubbornly
fragile, prosecuting frauds would destabilize a weak recovery. These prevailing political-economic
attitudes of government officials and politicians allowed fraud to flourish in the name of stability,
but this perspective is fundamentally flawed, as control fraud theory demonstrates that unchecked
fraud erodes confidence in the financial system and inflates the bubble of the next financial crisis. These recent developments illustrate the unlearned lessons from Enron and persistent threats
from corporate-financial crime.
A common limitation of the existing framework is the reliance on regulators who often
have similar views to those they are supposed to be regulating. Regulators are often taken from
the industry they are responsible for regulating, creating an inherent conflict of interest. The
justification is that industry insiders are capable regulators due to their intimate knowledge of
industry inner workings. The give-and-take relationship between regulators and industries has
made regulatory systems increasingly complex and many ordinary individuals lack the capacity
for understanding these complications, thus supporting the insider-only preference. While the
SEC was first created due to Insull and related securities frauds of the 1920s/1930s, the SEC
182
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
Analysis of collapses of Insull and Enron
later proved to be an inadequate regulator, as it failed to uncover abuses both prior to and after
the passage of the Sarbanes-Oxley Act of 2002 (King et al., 2009). Part of the problem may be
attributed to an inadequate enforcement budget (Skeel, 2005), but also to an ideological perspective of many regulators favoring self-regulation as a more effective approach than command
and control.
Several ideas have been proposed to address regulator conflict of interest. One alternative is
to promote individuals from outside an industry to regulatory agencies. CFOs and CEOs could
be required to report to outside regulators in non-technical language. This would eliminate the
perceived need for industry insiders with intimate industry knowledge. This was one response to
the BP oil crisis, as the Minerals Management Service (MMS) had followed this pattern and the
agency was broken into several pieces with new leadership from outside the industry appointed
to restructure oversight of the oil and gas industry (Soraghan, 2010). This could be a step in the
right direction for reform, but relationships between industry and regulators should be given
greater attention. Another alternative is to require the assignment of independent auditors and
analysts to companies instead of allowing them to choose their own auditors. This idea was proposed during the 2010 financial regulatory reform discussions to address credit rating agencies
whose positive ratings on subprime mortgage-backed securities contributed to the 2008 financial
crisis. The proposal to create new conflict-of-interest rules for ratings companies by requiring
the random assignment of ratings agencies was dropped during final congressional negotiations
(Herszenhorn, 2010). While many other ideas have been discussed, regulatory failure is likely to
continue in the future. Political constraints continue to weaken reform efforts. Regulatory effectiveness depends heavily upon the political will to appoint effective external regulators, which is
not likely to be resolved without a reconsideration of the fundamental role of regulatory agencies
in overseeing the private sector.
Improved corporate citizenship is a necessary element in reducing corporate crime, but claims
by corporate offenders that they are best left to fix themselves should be treated with cautious
skepticism. The limits of self-regulation evident in Insull and Enron illustrate the dangers of
an entirely hands-off approach to corporate law enforcement. Creative methods of addressing ethical shortcomings should be assessed, implemented, and evaluated. One strategy involves
improved ethics training for business students and corporate leaders to promote awareness of the
damages caused by reckless, purely profit-focused decision making and the negative influences of
criminogenic corporate cultures. Enron brought increased focus to the previously obscure topic
of business ethics in MBA schools (McBarnet, 2006), as graduates were concerned only with
obtaining large profits by any means necessary (Grey and Clark, 2002). Further research on these
programs should be conducted to determine their effectiveness.
These problems lack clear and easy solutions. Potentially harmful relationships between government and corporations are well established and elites seem content with maintaining the
status quo. One basic solution may rest in simply raising public awareness that these exchanges
can result in large-scale social harm if unchecked. After Enron, despite claims by many that the
recent corporate crime waves only consisted of a few “bad apples,” there was a broader realization
that these problems are not limited to just a few corporations (McBarnet, 2006; Moohr, 2007).
However, public anger was largely directed toward individual corporate offenders instead of
targeting the criminogenic environment. Reform measures more often than not contain numerous loopholes later exploited while key provisions are watered down over time. Politicians alone
should not be relied upon to address problems they helped to create. The public must demand
accountability for government and corporate actors by becoming more aware of elite corporatefinancial crimes and pushing for balanced measures promoting stability and justice in the financial and justice systems.
183
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
B.A. Sullivan
References
Anderson, Douglas D. (1981). Regulatory politics and electric utilities: A case study in political economy. Boston,
MA: Auburn House Publishing Company.
Aronson, Neil H. (2002). Preventing future Enrons: Implementing the Sarbanes-Oxley Act of 2002. Stanford
Journal of Law, Business and Finance, 8, 127–153.
Barak, Gregg. (2012). Theft of a nation: Wall Street looting and federal regulatory colluding. New York: Rowman &
Littlefield.
Benson, Michael L. and Simpson, Sally S. (2009). White-collar crime: An opportunity perspective. New York:
Routledge.
Black, William K. (2005). The best way to rob a bank is to own one: How corporate executives and politicians looted
the S&L industry. Austin, TX: University of Texas Press.
Black, William K. (2013). Mueller: I crippled FBI effort v. white-collar crime, my successor will make it worse.
Available at: www.neweconomicperspectives.org/2013/08/mueller-i-crippled-fbi-effort-v-whitecollar-crime-my-successor-will-make-it-worse.html.
Bonbright, James C. (1972). Public utilities and the national power policies. New York: Da Capo Press.
Bumiller, Elizabeth. (2002, July 31). Corporate conduct: The President; Bush signs bill aimed at fraud in
corporations, New York Times. Available at: www.nytimes.com/2002/07/31/business/corporate-conductthe-president-bush-signs-bill-aimed-at-fraud-in-corporations.html.
Coffee, John C. (2002). Racing towards the top? The impact of cross-listings and stock market competition
on international corporate governance. Columbia Law and Economics Working Paper No. 205. Posted June
15, 2002. Available at: www.papers.ssrn.com/sol3/papers.cfm?abstract_id=315840.
C-SPAN. (2013). Justice Department Oversight. Available at: www.c-span.org/video/?311311-1/justicedepartment-oversight.
Cudahy, Richard D. and Henderson, William D. (2005). From Insull to Enron: Corporate (re)regulation after
the rise and fall of two energy icons. Energy Law Journal, 26(35), 1–90.
Cunningham, Lawrence A. (2003). The Sarbanes-Oxley yawn: Heavy rhetoric, light reform (and it just
might work). Connecticut Law Review, 35, 915–987.
Geis, Gilbert. (2007). White-collar and corporate crime. Upper Saddle River, NJ: Pearson Prentice Hall.
Gerding, Erik F. (2006). The next epidemic: Bubbles and the growth and decay of securities regulation.
Connecticut Law Review, 38, 393–450.
Grey, Kenneth R. and Clark, George W. (2002). Addressing corporate scandals through business education.
International Journal on World Peace, 19(4), 43–62.
Healy, Paul M. and Palepu, Krishna G. (2003). The fall of Enron. Journal of Economic Perspectives, 17(2), 3–26.
Herszenhorn, David M. (2010, June 15). House–Senate talks drop new credit-rating rules, New York Times.
Available at: www.nytimes.com/2010/06/16/business/16regulate.html?_r=0.
King, Matthew R., Corrigan, Elizabeth and Dukin, Craig F. (2009). Securities fraud. The American Criminal
Law Review, 46, 1027–1098.
Lynch, Michael J., McGurrin, Danielle and Fenwick, Melissa. (2004). Disappearing act: The representation
of corporate crime research in criminological literature. Journal of Criminal Justice, 32, 389–398.
Markham, Jerry W. (2006). A financial history of modern U.S. corporate scandals: From Enron to reform. Armonk,
NY: M.E. Sharpe.
McBarnet, Doreen. (2006). After Enron will “whiter than white collar crime” still wash? British Journal of
Criminology, 46, 1091–1109.
McDonald, Forrest. (1962). Insull. Chicago, IL: University of Chicago Press.
McLean, Bethany and Elkind, Peter. (2003). The smartest guys in the room: The amazing rise and scandalous fall
of Enron. New York: Portfolio.
Moohr, Geraldine S. (2007). Of bad apples and bad trees: Considering fault-based liability for the complicity
corporation. American Criminal Law Review, 44(4), 1343–1364.
Munson, Richard. (2005). From Edison to Enron: The business of power and what it means for the future of electricity. Westpoint, CT: Praeger.
NYT. (1934a, November 25). Insull acquitted with all 16 aids in quick jury vote. New York Times.
NYT. (1934b, May 8). Insull is landed; says he will fight for “vindication”. New York Times.
NYT. (1934c, October 24). Says Insull sold his “dying” stock. New York Times.
NYT. (2001, November 29). The markets: Stocks and bonds; Investors pull back as Enron drags down key
indexes. New York Times. Available at: www.nytimes.com/2001/11/29/business/the-markets-stocksbonds-investors-pull-back-as-enron-drags-down-key-indexes.html.
184
Downloaded By: University College London At: 11:53 24 Oct 2017; For: 9781315815350, chapter11, 10.4324/978131581535
Analysis of collapses of Insull and Enron
NYT. (2006, October 23). Enron Scorecard. New York Times. Available at: www.nytimes.com/ref/
us/20061023_ENRON_GRAPHIC.html.
O’Brien, Justin. (2005). Ethics, probity, and the changing governance of Wall Street: Cure or remission?
Public Integrity, 7(1), 43–56.
Oppel, Richard A. and Berenson, Alex. (2001, August 15). Enron’s chief executive quits after only 6 months
in job. New York Times. Available at: www.nytimes.com/2001/08/15/business/enron-s-chief-executivequits-after-only-6-months-in-job.html.
Oppel, Richard A. and Sorkin, Andrew Ross. (2001, December 3). Enron’s collapse: The overview; Enron Corp.
files largest U.S. claim for bankruptcy. New York Times. Available at: www.nytimes.com/2001/12/03/
business/enron-s-collapse-the-overview-enron-corp-files-largest-us-claim-for-bankruptcy.html.
PBS. (2013). The Untouchables. Frontline. Available at: www.pbs.org/wgbh/pages/frontline/
untouchables/.
Pontell, Henry N., Black, William K. and Geis, Gilbert. (2014). Too big to fail, too powerful to jail? On
the absence of criminal prosecutions after the 2008 financial meltdown. Crime, Law and Social Change,
61(1), 1–13.
Prechel, Harland and Morris, Theresa. (2010). The effects of organizational and political embeddedness on
financial malfeasance in the largest U.S. corporations: Dependence, incentives, and opportunities. American Sociological Review, 75(3), 331–354.
Rockness, Howard and Rockness, Joanne. (2005). Legislated ethics: From Enron to Sarbanes-Oxley, the
impact on corporate America. Journal of Business Ethics, 57(1), 31–54.
Simpson, Sally S. (2002). Corporate crime, law, and social control. New York: Cambridge University Press.
Skeel, David A. (2005). Icarus in the boardroom: The fundamental flaws in corporate America and where they came
from. Oxford/New York: Oxford University Press.
Soraghan, Mike. (2010, June 16). Interior’s new oil industry watchdog has little energy experience. New York
Times. Available at: www.nytimes.com/gwire/2010/06/16/16greenwire-interiors-new-oil-industrywatchdog-has-little-43108.html?pagewanted=all.
Spivack, Peter and Raman, Sujit. (2008). Regulating the “new regulators”: Current trends in deferred prosecution agreements. The American Criminal Law Review, 45(2), 159–193.
Van Niel, Jeremy D. (2009). Enron: The primer. In N.B. Rapoport, J.D. Van Niel and B.G. Dharan (eds),
Enron and other corporate fiascos: The corporate scandal reader (2nd edn, pp. 61–84). New York: Foundation
Press.
Wasik, John F. (2006). The merchant of power: Samuel Insull, Thomas Edison, and the creation of the modern Metropolis.
New York: Palgrave Macmillian.
Windsor, Duane. (2009). Business ethics at “the crooked E”. In N.B. Rapoport, J.D. Van Niel and B.G.
Dharan (eds), Enron and other corporate fiascos: The corporate scandal reader (2nd edn, pp. 123–150). New
York: Foundation Press.
185