Enron - How To Get Away With Stealing

I'd always thought the gravest financial crimes were committed by bank robbers, cybercriminals, or politicians until I discovered that theft on a large scale, required smartness, boldness and all the other stuff they tell you to cultivate in the corporate world.

This is a story about Enron, the seventh largest company in the world in 2001...and the recipe for conducting financial crime in the face of everyone without them knowing — smartness, innovation and of course, greed.

Enron was the darling of Wall Street. Named Fortune's most innovative company for six years consecutively, who wouldn't want to be affiliated with a brand that could go on to become the "ULTIMATE COMPANY." (or so we thought?)

The Beginning

It all began in 1982 when one Kenneth Lay was recruited by his former boss and college professor to become the number 2 man at Transco, a pipeline company in Houston, Texas.

Before his recruitment, Ken Lay had worked his way through the ranks in his career, graduating as one of the best Economics students from the University of Missouri, completing a Ph.D. in Economics while working in the oil and gas industry, serving in the U.S. Ministry of Interior and as a top operator in Florida Gas Corporation.

Shortly after, Lay joined Transco, where he made his first major industry mark.

Transco had entered a series of contracts with different oil drillers and producers in the U.S. to buy natural gas at an ever-increasing price (the price of oil in the U.S. had been increasing continuously for over 5 years at the time). However, market prices of oil assets took a hit and fell, putting Transco at risk of bankruptcy because of the deals they've entered.

Lay puts his PhD in Economics into play. He takes advantage of the deregulation happening in the energy market at the time by sort of creating a spot market for natural gas, where producers would sell directly to retailers at real-time prices instead of pipeline companies buying all of these assets and going through the stress of reselling them to retailers. This revolutionary idea saves Transco and makes him an industry legend.

In 1982, the wave of Lay's success reached Houston Natural Gas (HNG), which offered him the job of becoming chairman and CEO of the company. And like all career-oriented individuals, Lay grabs the job, becoming the number one man in a rising oil firm. Who wouldn't?

A few months into his first CEO experience, another energy corporation, InterNorth, based in Omaha was at the risk of a hostile takeover. They propose a merger deal with HNG.

The merger was successful, and like one destined for the top, Ken Lay became the CEO of the new company which he rebranded to Enron - an energy trader and supplier following his original innovation of facilitating spot trading for gas.

At the time, McKinsey was a consultant for Enron and like Ray in his days at Transcorp, one of its partners, Jeffery Skillings, came up with a bright business idea that could significantly increase the revenue of Enron.

The New Business Model

Jeffery Skillings, after earning his MBA from Harvard Business School as one of the top students, went on to work at McKinsey and Co. as one of the youngest partners in the company's history. It was in this role that he encountered Ken Lay and Enron.

Like a match destined by the gods, the duo immediately had a connection.

Skillings' idea for Enron was to expand the innovation of Lay beyond the spot market to a sort of derivatives market for natural gas. Take away the pipelines and build a stock market for the assets it transports. All this was possible because of the deregulation of the energy market in the 80's to 90's.

Here's how it would work:

Enron would go to producers and buy all of their future gas produce at a set price, repackage it as a sort of security, and allow buyers and sellers to trade futures contracts based on the underlying gas commodity.

"A futures contract is like entering an agreement to buy/sell something in the future at a particular price regardless of its current market price.

The logic here is that locking down price allows you to hedge risk in case of price fluctuations."

Ken Lay and the executives at Enron loved the idea and decided to recruit Skillings to come over and establish this business by becoming the CEO of a new division within the company - Enron Finance.

Skillings would go on to accept the deal but under a condition.

Jeff Skillings mandated Enron to switch its accounting method to mark-to-market accounting before he could join them and head this new division. Ken Lay agrees.

And in 1990, Skillings joined as the CEO of Enron Finance. This is where the story gets interesting.

Creative Accounting - Enronomics

Enron took this new accounting method to its third-party accounting firm, Arthur Andersen and the U.S. Security and Exchange Commission (SEC) for approval. The SEC hesitates at first but later gives the go-ahead in 1992 after Skillings convinces them.

A bit about mark-to-market accounting:

Mark-to-market accounting allows you to estimate the cost of an asset based on the current market value. This is as opposed to historical cost accounting which estimates the costs of assets based on the original cost you purchased it for in the past.

With Ken Lay giving a nod, Skillings began the practice of creative accounting within Enron.

They approach oil drillers with the idea and promise to finance them in exchange for allowing them to buy all of their future gas produce.

Skillings, through mark-to-market accounting, would aggressively overestimate all of the potential future earnings of these deals with producers and record it as revenue today. Hence, Enron went on to report massive gains from their investments on their income statements without accounting for expenses.

It's like buying a $5k asset that you believe would be potentially worth $20 million in the future. Then you go about and tell the world you're a millionaire today because of that 'belief.'

The problem with this approach is that it empties all your potential revenue from the future and brings it into the present. Plus, if the deal doesn't yield the projected revenue, you would be incurring a huge loss.

This means that during the earning calls of the next year, Enron would have no revenue report plus a huge amount of loss if the deals with producers didn't bring in the overestimated returns.

As a result, Enron had to enter several new deals and businesses every year to report revenue growth. They also devised ways to get those earlier bad investments with producers off their books if they didn't meet their overestimated value.

Enron didn't bother to analyse whether these deals with drillers were a good investment or not. As long as they have creative accounting, they can record high profits on their income statement even when they make bad deals. But how do they escape the losses from those bad deals? We'll get to it shortly.

Skillings began to recruit traders and financial experts from other companies and several MBA programs across the U.S. One of his key recruits was Andrew Fastow, a former employee of Continental - one of U.S. largest banking failures.

Skillings and Fastow got to work and they set up a kind of business arm known as a special purpose entity (SPE) they became familiar with through Arthur Andersen.

At the time, a company can set up such an entity, transfer assets/investments that are making losses from their books into it, and refer to it as an independent firm - as long as 3% of the money financing the entity comes from external investors. 

So, Enron repackaged the bad investments with drillers, sold them to the SPEs for an astronomical value and recorded those sales as revenue again. They were creatively selling their own poor investments to themselves for unreasonable high prices and recording it as revenue for the second time.

Remember, Enron owned the SPEs in reality but due to their nature they could tell the public that the SPEs are independent firms.

The SPE, in turn, funded these deals with money they borrowed using Enron's stocks as collateral.

Note: Mark-to-market accounting and SPEs are legal but subject to abuse.

Enron went on to make several other strategic investments in different industries adopting this model. Some notable ones include:

Enron Broadband - A strategic partnership with Blockbuster that would bring video on demand to consumers. Enron recorded a revenue of over $110 million from this deal even though it didn't yield any profit - because Blockbuster walked out of the deal.

Dabhol Power Station - Enron invested hundreds of millions into building a liquified natural gas power plant in India and recorded billions of revenue from the investment even though the power plant never went online.

EnronOnline - A website for trading commodities where Enron was the counterparty to each trade, enabling them to manipulate commodity prices. Their major strike was The California Energy Crisis.

And many other businesses.

All of these were preplanned and went into full swing in 1996.

If you've gotten here, you may be wondering, how was Enron making real money? I get that they are reporting huge revenue gains on paper and hiding losses from their toxic investments but what's the essence? Where are they making the real money?

Nowhere. The company wasn't making money in reality. Skillings and Fastow, with the approval of Ken Lay, were fooling regulators, financial entities, and the general public through creative accounting. But of what essence?

The Darling of Wall Street (1996 - 2000)

Now, when you report such huge revenue and net income coupled with very small losses, Wall Street (the trading capital of the world) goes crazy about your stocks.

Rating agencies rated Enron highly. Wall Street analysts were recommending a buy. Regulators respected them. And its auditing/accounting firm, Arthur Andersen, was one of the most reputable in the world at the time. Enron was even presenting awards to officials of government agencies and funding several charity programs in the U.S.

In the face of these circumstances, as you would predict, the price of Enron stocks soared in the market. Enron reported revenue growth of 750% from below $13.3 billion in 1996 to over $100.7 billion in 2000. As a result, the company's stock skyrocketed to a peak of $90 in 2000 from trading just above $20 in 1996.

During this period, Enron began to issue new stocks to the public in exchange for cash - of which a large part was used to fund the lavish lifestyles of Lay and Skillings. Also, their "healthy earnings and low debt" enabled them to easily take loans from several banks including JP Morgan, Citigroup, Deutsche Bank AG, and Merril Lynch.

As stocks were soaring, Ken Lay advised employees to get paid in stocks. He even convinced them to put their 401k (pension account) in Enron stocks saying that the stocks can only go one way - UP.

Due to the outrageous growth of Enron (on the outside), Fortune named it America's most innovative company for straight six years (1996 - 2001) and best-managed company in the year 2000.

While all this was going on, Skillings' 'hard work' in the company shot him to the position of President and COO of the entire Enron Corporation. Andrew Fastow, on the other hand, became CFO and Head of Corporate Affairs.

Here's a summary of the whole Enron flywheel:

But this isn't all.

The California Blackouts of 2000 - Enrontricity

While running other schemes in the stock market, Enron decided to exploit deregulation in the California energy market to make power tradable. However, unlike the natural gas market, it was harder to tweak the electricity market.

But the traders at Enron won't go down without a fight. They came up with a way to buy up large chunks of the power in the state, creating artificial demand and reselling it back to citizens at higher prices.

In times of high demand, Enron traders would call an executive at an Enron power plant and instruct them to take the plant offline for some hours. Due to this fake scarcity, they would inflate power prices and make millions of dollars off it before turning the power back on. The traders had different names for these manipulation strategies such as "Ricochet", "Get Shorty", "Fat Boy", "Big Foot", etc.

The state of California reported several blackouts and a loss of around $40 - 45 billion in the space of six months before the US Senate imposed price control on electricity sales. Where do you think a good percentage of that money went? Enron traders made the company well above $2 billion from the electricity crisis.

This was when public sentiments about Enron started taking a twist.

The Beginning of The End (2000 - 2001)

“From an accounting standpoint, this will be our easiest year ever. We've got 2001 in the bag." - Rick Causey: Enron's Chief Accounting Officer

The year is 2000 and Enron had become the seventh largest company in the world, raking in a market capitalisation of $70 billion. Ken Lay, with the help of his cohorts - Jeffrey Skillings and Andrew Fastow - had built a corporation that may go on to become the ULTIMATE COMPANY.

All was going green for Enron until Jim Chanos.

Jim Chanos of Kynikos Associates - a firm specialised in short-selling stocks - discovered a discrepancy in the accounting of Enron that made him believe something was off in the company's records. He couldn't figure out how the company was making real money. As a result, he began shorting the stocks of Enron regardless of public sentiments - oh, almost everyone loved the stocks of Enron.

However, upon his discovery, suspicions began to rise but slowly.

Then in February 2001, Ken Lay stepped down as CEO but remained chairman of the board. Jeffrey Skillings assumes his position and shortly after, things begin to get messy. Reporters would question Skillings and Fastow on how Enron was making money and they would cut corners with words like "how we make money is a secret that we don't want our competitors to know."

The signs of the cracks became more visible when Jim Chanos shared his thoughts with a new journalist at Fortune, Bethany McLean, who went on to publish an article in March 2001 with the title, "Is Enron Overpriced."

Following the wide effect of the article in April 2001, an analyst questions Skillings during his first earnings call as CEO with the following words, "You're the only financial institution that can't produce a balance sheet or cash flow statement with their earnings..."

And Skillings was like "Thank you very much... Uhm... We appreciate it... asshole"

This was the visible reason that everyone needed to believe that Enron may not be what they thought it was.

As the heat gets worse, Skillings suddenly retires barely seven months as CEO, selling most of his stocks for hundreds of millions while going out.

Ken Lay returns as CEO after secretly taking cash loans from the company using his Enron stocks as collateral. He made well over $300 million from the sale of a large part of his stocks. The same man who asked employees to leave their pension accounts in Enron stocks.

Amid these issues, an executive within the company, Sherron Watkins, released an anonymous internal memo drawing Ken Lay's attention to all of the irregularities in their accounting. But he does nothing about it. She later becomes the whistleblower who went to the government.

Arthur Andersen, Enron's third-party accounting/auditory firm, seeing its role in all of these by making the public believe Enron was doing well, sent a mail to its offices across the country, instructing them to shred all documents about Enron. The shredding lasted for about two weeks.

The board at Enron discovered that Fastow had secretly stolen over $40 million through the management of those special purpose entities. They sacked him immediately and replaced him with the former company treasurer.

Days later, the treasurer and his team discovered a huge pile of debts that Skillings and Fastow had moved into their SPEs. Enron had to restate its earnings back to 1997, reporting a loss of $591 million and debt amounting to $690 million.

Ken Lay tries to save the company in a last-ditch effort by going over to Enron's largest competition, Dynergy for an acquisition deal. Dynergy initially agreed and all was set for the salvation of Enron until they discovered the company's large debts during due diligence.

Dynergy pulled out of the deal and when the news got out, it became clear to everyone that Enron had been fooling the whole world through their creative accounting schemes.

Free Fall

From trading at a record high of $90 in 2000, Enron stocks crashed to $0.61 in November 2001 - a 99% decrease. That is, if you had invested $10,000 in 2000, it would have depreciated to $61 by November 28, 2001.

Enron filed for bankruptcy in December 2001, which was the largest bankruptcy in the world at the time.

The thousands of Enron employees who had their pension in the company stocks lost all of their life savings - worth billions of dollars - after years of hard work. Shareholders lost about $74 billion in total.

The SEC began looking into the case and after full investigations, several of Enron's top executives were found guilty and convicted on several counts of wire and securities fraud, insider trading, and a lot of other crimes.

Ken Lay shockingly dies from a heart attack, days before his sentencing.

Fastow served five years in prison before he was released in 2011.

Skillings was originally sentenced to 24 years in prison but later served 12 years after appeal. He was released in February 2019.

Arthur Andersen's license was revoked and the company closed down, leaving its 30,000 employees jobless at the time.

Several regulations were reviewed and enacted in the wake of the Enron scandal, including the Sarbanes-Oxley Act which demanded high transparency from companies in their financial reporting, stricter punishment for fraud, and executives signing on financial statements.

Enron's rise and fall is a classic case of how a poorly regulated environment and public greed can create a fruitful environment for crime. In the end, it was a company that had huge revenue on paper but zero cash flow in reality.

My Two Cents

• Greed corrupts your smartness and turns into foolishness.

  Most of the ideas Enron wanted to establish would later go on to change the world but they weren't patient enough. The natural gas derivatives market, video on demand, and broadband all went on to become revolutionary businesses a few years after Enron's demise.

• No crime can last forever no matter how smartly played. And when it comes out, it usually blows up in the face of its perpetrators.

• Address bad behaviour in your organisation immediately whether you're a small or large business owner. Lay died because he ignored the several financial crimes his trusted executives perpetrated.

If you like this story, you won't want to miss out on the interesting business stories we have prepared for the coming weeks.

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Till I come your way next week, ensure you don’t invest in companies like Enron or become one.

Sources

https://www.investopedia.com/updates/enron-scandal-summary/

https://www.npr.org/2006/07/05/5535821/timeline-ken-lay-and-the-arc-of-enron

https://en.wikipedia.org/wiki/Enron_scandal

https://www.acquired.fm/episodes/enron

https://www.imdb.com/title/tt1016268/

https://open.spotify.com/episode/1Q02zz8JwrPp0GMWXUaA04