Enron: The Smartest Guys in the Room

The story of Enron’s spectacular rise and collapse is a foreshadowing of the 2008 financial crisis. In the movie Enron: The Smartest Guys in the Room, we learn how a small company takes advantage of a change in the laws to puff itself through fraud and bluff into the sixth largest company in the USA only to collapse overnight.

Although the film is a documentary, the story is so amazing it held my attention throughout its 110 minutes. It contains many practical investment lessons. There is, however, some nudity, swearing and the depiction of a suicide.

This article is 1500 words, if you don’t have time to read it now you can skip to the bottom to find my list of market lessons.

Beginnings

Enron was founded in 1985 by Ken Lay after he successfully lobbied the US government to deregulate its energy markets. Deregulation of an industry means the government has less control over it. The government sells any facilities it owns in that industry and stops setting limits on the prices that can be charged. Private companies are allowed to enter the industry and compete to offer their services to consumers.

Done correctly, deregulation can lead to cheaper prices and better services because the companies are motivated by the competition to eliminate inefficiencies and outperform their competitors. But when there are few companies in a market, they might collaborate instead of compete and the consumer can be worse off than before.

The purpose of Enron was to take advantage of the energy market deregulation. Thanks to Ken Lay’s friendship with George Bush Senior, Enron was quickly given $2 billion in government grants. That’s an advantage most new businesses don’t get. If you think that’s extraordinary, I can tell you it’s only the beginning.

Trading frauds and cover-ups.

So Enron started well enough. However, in addition to being a power company, Enron operated a trading desk, where energy futures could be bought and sold to other users and investors. In 1987 two of its traders made huge profits on Enron’s behalf. The profits were so huge some of the directors were alarmed because they realized the traders were gambling with the company’s money.

One of the directors investigated and found that the two traders were not only taking huge risks to make such big profits, they were also stealing millions of dollars. The director reported his findings to Mr Lay and other senior directors. But instead of sacking the traders, Mr Lay encouraged them to continue, thinking the profits would keep coming. Two months later, the traders’ luck turned against them and they started making such huge losses the company was almost destroyed. Enron only survived because it brought in an experienced trader to sell out its positions without scaring the market into a panic.

After such a near-death experience you would think the company would become more conservative. Instead Mr Lay wanted to hide the huge losses and continue gambling. A new Chief Executive Officer (CEO), Jeff Skilling, was appointed and he introduced mark-to-market accounting. This accounting system allowed the company to book the potential profit from a deal when the deal is signed, regardless of whether a profit was actually made as a result of the deal.

Enron also began trading in energy derivatives. These are investments which are almost entirely disconnected from the reality of supply and demand for electricity. They are similar to the mortgage derivatives traded in the years before the 2008 market collapse. As you might imagine, these derivatives can bring big profits, but they also magnify any losses.

The nature of the derivatives became increasingly remote from reality. Enron tried to trade internet bandwidth but found the technology to do that didn’t work. Even so, the company booked huge profits because of their mark to market system. At one point, they even attempted to trade weather futures.

With the increased importance of traders, Enron started to acquire a toxic employee culture. Every year employees were graded and the lowest 10—15% were sacked. On the other hand, a successful trader would be given millions of dollars as a bonus.

Enron continued to make further losses. However, as long as its accounting system allowed it to hide the losses, it reported increasingly higher profits.

Wall Street Conspiracy

As long as the company met or exceeded analysts’ profit expectations, the analysts did not investigate how the profits were made and they continued to mark up their estimates of the share price value. One of the few analysts to publicly doubt Enron’s figures worked for Merrill Lynch. Enron put pressure on his bosses and he was fired. Soon after, the bank was rewarded with two $25 million investment banking jobs.

Enron was acclaimed as having a new business model. Newspapers and magazines printed articles praising Mr Lay and Mr Skilling. At the same time, Enron was losing billions on various projects around the world.

An example of one project was a power plant Enron built off the coast of India. It cost over $1 billion, but the Indian government did not need it, there was already plenty of supply. Anyway, the high electricity prices Enron needed for it to make a profit were far above the market price. So the power plant was never used. Even so, Enron executives involved in the project were paid tens of millions of dollars in bonuses because they booked the potential profit, not the real loss, using mark to market accounting.

By this time, the losses were so huge they could not be hidden, even by mark-to-market accounting. So Enron’s Chief Financial Officer (CFO) created hundreds of new companies and stashed huge amounts of debt into them. At the same time he was able to skim millions from Enron into his own pockets. The company’s auditor, Andersen Consulting approved this arrangement and this conspiracy only worked because of the collaboration of many of the big banks who surely knew what was going on.

In 1997, Enron purchased a West Coast energy company, Portland General Electric (PGE). PGE employees thought Enron was a solid, conservative company just like PGE and allowed all their shares in PGE to be transferred into Enron stock.

Owning PGE gave Enron access to the California energy market. It was able to use its position as a supplier to manipulate the market. One of its favorite tricks was to shut down power plants to force prices up. In addition to causing chaos in America’s biggest state, Enron made $30 billion at the expense of California taxpayers. It still wasn’t enough to pay for all its huge trading losses.

Interestingly, the power disruptions attracted the attention of some Australian gas producers, particularly BHP, who thought there must be a real energy shortage in the USA. For several years they attempted to gain permission to build offshore terminals so they could export gas to the US. This project was unsuccessful because of resistance from Hollywood stars who didn’t want their ocean views interrupted. Imagine how much money BHP would have wasted if they had been given permission to build those useless terminals?

Eventually, one fund manager did his homework and noticed Enron’s financial reports were lacking information, yet it seemed impossible for it to make the sort of profits it was claiming. He tipped off a journalist who eventually wrote an article in Fortune magazine questioning Enron’s profitability. This put pressure on Skilling who eventually lashed out at an investor during an investment conference. After this, things started to unravel for Enron.

The directors started selling their shares while encouraging employees to buy more, even to put all of their savings into Enron stock. When the share price fell to $38, the employee retirement accounts were frozen, while the executives continued to sell down their stock. Just before the company collapsed in 2006, Ken Lay said publicly that its fundamentals were strong.

In the end:

  • a company which had been valued at $70 billion, the sixth biggest in America, was revealed to be worth less than nothing;
  • 20,000 employees lost their jobs. They received a few thousand dollars in compensation while the executives received millions in bonuses;
  • employee retirement funds lost over $2 billion;
  • Arthur Andersen’s reputation was ruined and that company fell into bankruptcy too, disrupting the lives of its 29,000 employees; and
  • some of the directors were tried and a few were sent to jail. Skilling was sentenced to 28 years but it was reduced to 14 thanks to his spending $millions on lawyers. Ken Lay died of a heart attack while waiting for an appeal, he died a free man, the millions of dollars he took were in overseas bank accounts and have never been recovered.

Some market lessons from this:

  • deregulation of a market can create value (the process of deregulation is still incomplete in China, which is why I am confident there will not be a recession there for many years);
  • don’t invest in companies using mark-to-market or other inventive financial accounting styles;
  • beware of companies with a toxic culture;
  • beware when the press praises a company excessively, especially when they say it is breaking with convention because of its new business model;
  • never invest all your funds in a single company;
  • don’t trust directors or analysts unless they can back up their statements with checkable facts;
  • If you are an employee, don’t put all your faith in your employer.

Funnily enough, Enron’s motto was ‘Ask why’. If more people had asked why, the company would have collapsed earlier and much less money would have been lost.

What other lessons can we learn from Enron’s collapse? Add your thoughts in the comments section below.

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