How did one of the world’s largest companies go caput in a matter of weeks? Before the house of cards came tumbling down, did no one ask Why?
Last week I watched a fantastic film called Enron: the smartest guy in the room (sign in on Vimeo to watch for free).
It’s about one of the largest and most complex accounting scandals of all time, the story of how Enron Corporation – the US-based energy, commodities, and services company – tricked its investors, and the world, into thinking it was doing much better than it actually was.
Enron seemed to be going, in today’s parlance, ‘to the moon’. At their peak in mid-2001, Enron’s shares traded at $90.75. As the doors started to fall off their value plummeted, eventually falling to an all-time low of $0.26 shortly before Enron declared bankruptcy on 2 December 2001. Billions of dollars worth of value were wiped off pension funds. Many people lost their jobs, both at Enron and companies it had worked with; Arthur Andersen, one of the Big Five accounting firms, was torpedoed along with it. All of this was, in the context of what had previously been one of the most profitable companies in the world, quite unthinkable.
There are so many interesting and downright astounding things about Enron brought to light by Bethany McLean and Peter Elkind’s book and, later, film The Smartest Guy in the Room. I’ll highlight a couple and let you go off and read/watch for the rest.
One is the concerted use of Mark-To-Market accounting, which Enron was given approval for from the U.S. Securities and Exchange Commission (SEC) in 1992. Mark-To-Market accounting allows a company to record assets on its balance sheet at fair market value (ie what they should be worth) rather than their book value (ie what they’re actually worth). More particularly, using Mark-To-Market companies can report the money which they project they’ll make as actual profits without needing to provide the real numbers until later.
Enron and its employees were therefore incentivised to make it seem as though the company was doing really really well, as this would push the share price up (and up and up). This was particularly so as many of the top executives were remunerated in part with share options, so increased in the value of Enron’s shares directly added to their wealth.
Enron did suffer losses, but it shifted these into Special Purpose Entities (known as Raptors, read all about them here in this 2006 CPAJ article). It reported the losses in these Raptors (rather than in Enron’s own accounts), using a complex web of derivatives to keep them out of sight of its investors, who remained (at least for a time) unaware of the losses Enron was actually haemorrhaging.
A notable moment in Enron’s story is when it moved into the newly deregulated Californian energy market. California in the early 2000s was meant to be a new kind of energy market, one where free market dynamics would get the best prices and the best service to consumers. Pure, red-blooded capitalism. Enron certainly smelt blood.
Moving quickly Enron swooped in, establishing itself at the centre of a new kind of market which traded energy like any other commodity. With adverts showing it controlling lightning storms and other natural disasters, Enron claimed to “protect revenue against unfavourable weather”.
California soon grew to be one of Enron’s most profitable business centres, but its massive profits were built almost entirely on a variety of unethical (if not actually illegal) strategies. You can read about the main ones here.
One strategy that struck me as downright shocking is ricochet: Enron traders would export power to a nearby state, or elsewhere offshore, then notify one of the Californian factories they had close ties with that there was no demand, telling it to shut down for a few hours. Once the factory went down the baseline demand coupled with the limited supply meant that prices rocketed and the Enron traders could re-import that energy back into California and take home the margin.
The worst of it was that Enron ran this energy market. To participate you had to deal with Enron and its famously savage traders. Millions of lights went out across California, while at the same time Enron’s energy trading desks were raking it in as they manipulated the market.
The story of Enron’s collapse is an incredible lesson in hubris and it’s fascinating how this is revealed in Enron: the smartest guys in the room. Who knows, learning about it might actually make you Ask Why.
Rupert Swallow 