Twenty years ago tomorrow, Enron filed for bankruptcy. After that came the most famous corporate fraud case in U.S. history and significant changes in regulation.
Much of it is chronicled in a new podcast series, Bad Bets, which features John Emshwiller and Rebecca Smith, the Wall Street Journal reporters who unravelled the story. (Podcast episodes and transcripts are available here.)
Some of the story
The key players at Enron were Ken Lay, Jeff Skilling, and Andy Fastow. Lay was the firm’s long-time CEO, Skilling the widely-admired innovator who had a short stint as CEO during the firm’s last year, and Fastow the CFO whose financial engineering was first lauded and then condemned. All were ultimately convicted.
Once a “sleepy gas pipeline,” Enron made itself into a phenomenon, taking advantage of deregulation in the energy industry to become a trading powerhouse, while expanding geographically and getting into new businesses. One of those forays, into broadband, played a major role in the unwinding of the firm, but there were many contributing factors.
Over time, the firm increasingly pushed the ethical envelope. A famous example occurred in 1998, when stock analysts were invited to visit a sales room that had opened for a new line of business it was promoting. But the room wasn’t ready, so Enron employees were marshalled from other areas to populate the area and look busy. (The first episode of the podcast, “Potemkin Village,” is named in honor of that successful ruse. Similar stunts by other companies have fooled analysts over the years.)
Fastow was good at subterfuge, cutting corners, and doing things to beat the earnings estimates and growth projections the company promoted. He said later:
I should have been called Chief Loophole Officer. That’s all I did every day, and we were the best at it. The way I looked at it is whoever could best exploit those rules gives their company a competitive advantage, and it’s my job to give my company a competitive advantage. That was my job, to find loopholes.
The big loophole for Fastow was getting the board of Enron to allow him to serve as the general partner for some private partnerships doing business with the firm — while he was its CFO. Those partnerships were used to hide financial problems at the company and ultimately were key to its undoing.
In early 2001, Skilling took over the CEO role from Lay, who remained Chairman. He only lasted six months before he resigned in August and Lay became CEO again. The stock had peaked at $90 one year before, but by then had declined 55%. Skilling’s resignation prompted the WSJ to start its investigation.
In October the company announced a big loss and Fastow was forced to resign. (Meanwhile, Lay kept talking up the company and its stock to employees and analysts.) A few weeks later, Enron restated its financials for the previous four years. Another month and it was gone, less than a year after reporting annual revenues of $100 billion.
The analysts
Trying to figure out why Skilling quit, Emshwiller prepared for an interview with him. He read the “Related Party Transaction” section of a recent SEC filing for the company:
And there I found something most unusual, something that ended up being a big deal. Deep in the document was a reference to outside partnerships that were doing vast amounts of business with Enron, worth hundreds of millions of dollars.
Similar language was in previous filings. Why had the partnerships not been a focus of the analysts covering the company (or the large institutions that formed the core of its investor base)?
Carol Coale, who covered Enron for Prudential, recalled an analyst event in January 2000 when Skilling announced the firm’s aggressive move into broadband, saying it was “like a cult meeting because every single person was mesmerized. Everybody was on the same page. Everybody was caught up in the moment, including me.” The stock rose 26% that day.
A year later, Coale saw something else: a flood of Enron staffers in the broadband area looking for jobs. “I had proof, I had resumes in front of me, and folks I had talked to that were saying, ‘We think something’s amiss at Enron.’ ” But whenever she contacted the executives at Enron, they talked her out of downgrading the stock. Skilling even told her that she’d look foolish, because there would be some news coming out from the firm. Coale:
I mean, what would you do if the CEO told you something like that? I mean, I thought, “Well, okay, I don’t want to lose credibility. I don’t want to look stupid because this man is trying to save me from myself.” So I believed him. And at the time, I trusted him and I said, “Okay, I won’t do it now then, I’ll wait and see what your news is.”
It was, according to her, “a story stock.” Analysts who fight a story like that — or even question it — face significant career risk. (By the way, the promised news never came out.)
Another analyst, John Olson, said, “Ken [Lay] wanted strong buy recommendations, period. He didn’t care about anything else when it came to Wall Street.” And Lay pulled a deal from Merrill Lynch, Olson’s firm at the time, because he had rated the stock a hold. Olson was gone soon thereafter.
Wall Street analysts face pressure from all sides. CEOs are cajoling them to parrot the party line and convince their clients to buy. In addition, while reforms have lessened the overt pressure and incentives for analysts to help their firms get investment banking business, they haven’t gone away. And some large investors will withhold trading business if they don’t like an analyst’s rating on a favored stock. It’s no wonder that stories outrun reality and that sell-side analysts are usually behind the curve. They are pushed in that direction by the interests of others.
The enablers
The web of parties that fostered the Enron disaster went far beyond the analyst ranks.
Investment banks try to gain favor with hot companies and vie for their business. Merrill Lynch assisted Enron in a shady deal involving barges in Africa. One person at Merrill who objected to the deal was asked during the trial, “Why didn’t you, if you thought it was so bad, why didn’t you report it to compliance at Merrill Lynch?”
And she said, “Are you kidding? That’s not what compliance is for. And especially when you have the head of investment banking approving it, they weren’t going to do anything because I said it.”
The accountants, the auditors, the law firms. Everyone was approving and abetting Enron’s moves. (The lead Arthur Andersen partner ordered the shredding of around two tons of Enron documents when the SEC announced it had been informally investigating the company. As a result of its actions at Enron, Arthur Andersen didn’t survive.)
And then there was the board. Jim Timmins (the first Enron whistleblower to help the reporters, who revealed his identity on the podcast) said that the board “was very supportive of Enron management because the Enron share price had just continually ticked up through the years.” It approved all kinds of questionable deals and arrangements, based upon the recommendation of management and all of those other enablers who checked their boxes of approval. Tellingly, during the meeting when conflict of interest guidelines were waived in regard to the Fastow partnerships, those at the table were “more worried about the optics of the conflict than the conflict itself.”
The trajectory
This chart shows the return on Enron stock, with the absolute percentage in the top panel and the relative performance on the bottom. (Because of the dividends the company paid along the way, neither line goes to -100%, even though the stock was worthless.) It is easy to spot when the story went into high gear — and when it hit the wall.
Could it happen again?
Today’s environment is similar in many ways. A technology-driven bull market has resulted in historically high valuations, and there is new-era thinking everywhere. Large companies (to say nothing of more speculative names) that announce new initiatives can see sizable moves in their stocks. And all of those enablers are still mostly incented to keep the stories going, not to search for flaws or ask hard questions.
There won’t be another Enron in terms of the specifics, but we’ll revisit the pattern. A big blowup, lots of finger pointing, more regulation, and promises of “never again.” It’s built into the structure of our system (and the nature of our selves).
Surprising outcomes
A Texas Monthly article is titled, “In Praise of . . . Enron?” It includes quotes from people “waxing nostalgic” about their time at the firm. New markets and technologies were spawned by Enron and many in its ranks when it went under found success elsewhere:
Enron imploded with such cosmic intensity that its legacy became irredeemably dark. Yet Enron-born technologies and markets remain intrinsic parts of the energy, finance, and tech industries. A diaspora of its alumni have gone on to build innovative, successful companies in renewable energy, finance, even sporting goods. Enron also invested in developing technologies that, while they didn’t pay off at the time, demonstrated that the company possessed an insightful vision of the future.
Even more surprising is the series of lessons from what is known as “the Enron corpus.” After seizing the emails of many high-ranking employees at the company, the Federal Energy Regulatory Commission decided to release them to the public.
A 2017 New Yorker piece details what happened when researchers got ahold of that information. Among many other things, they have studied email-foldering behavior, the distribution of emails produced, how communication flows in a network, and deception theory (regarding how those sending disingenuous emails craft their messages versus others).
Spreadsheets were attached to many of those emails, and they have been vetted too. Tim Harford highlighted the work of Felienne Hermans, who analyzed them. As Harford writes of Excel, “It’s powerful, it’s flexible. It’s ubiquitous. It may not be the right tool, but it’s the tool that’s right there.” So it is used for all kinds of problems, including ones for which it’s not well suited. And Hermans found at least a quarter of those sampled had at least one calculation error — and many had extraordinary numbers of them.
These studies of emails and spreadsheets have provided unexpected insight into our work world. They also lead into questions about the needs of organizations to understand the patterns of conduct within them versus the desire of workers to not be monitored unnecessarily. (These ideas will come into play in an upcoming series on this site regarding the evolution of investment work environments.)
Lessons
At the conclusion of the last episode of Bad Bets, John Emshwiller says:
Perhaps if there’s one takeaway from the Enron saga, it’s that vigilance and skepticism by everyone involved are things that should always be in fashion.
Narratives can overpower analysis (and ethics). “Vigilance and skepticism” can be viewed as hindrances to the game as it is played, instead of being recognized as essential qualities for good work.
Published: December 1, 2021
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