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The failure of Enron in the early 2000’s is one of the largest bankruptcies in US history. Shareholders were wiped out, and tens of thousands of employees left with worthless retirement accounts. This book recounts the rise and fall of Enron, and how the company constructed a massively complex accounting scandal that was doomed to failure.

Enron’s downfall is the predictable mixture of human greed, poorly structured incentives, and lack of sanity checks when everyone has their fingers in the pie. In smaller ways, we too are subject to the same pulls as Enron managers and employees. The warning - if we were put into the same situation, we might not have behaved any differently.

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Stakeholders/watchdogs overlooking bad behavior as long as they were profiting

People who could have stepped in and intervened didn’t, often because they had a large personal stake in Enron’s success. Further, the more Enron became a success (like in terms of stock price or deal flow), the more beholden the stakeholders were to Enron.

  • Shareholders (employees and the public in general) didn’t look very hard, as long as the stock price rose and employees got bonuses. Why stop the party?
  • Enron’s accountants (Arthur Andersen) couldn’t lose Enron as a client (Enron kept accountants waiting in the wings), so they tolerated their practices despite internal skepticism. Furthermore, Enron gave many Andersen accountants cushy jobs.
  • Investment bankers earned large fees from Enron’s complicated deals, even when they knew they were skirting the intent of the law. Bankers who ran bigger deals got promotions. They competed for Enron’s business.
  • Buy-side analysts at banks who were supposed to be independent were strongly pressured to give buy ratings, since companies would only work with positive banks.
  • Short sellers were a useful counterforce, since they had a large incentive to expose wrongdoing.

Lesson: Correct for your own incentive bias when you analyze a situation.

Looking to others believing they had done their due diligence

When you have multiple reputable people on board, everyone thinks everyone else has done their diligence. Surely all these other people can’t be wrong! In reality, no one has done their diligence.

  • Employees thought the board and accountants would keep bad behavior in check, and thought public markets were heavily incented to detect bad behavior.
  • The board trusted the internal risk department, which in reality was a yes-man and thought their only job was to sign off on deals.

Lesson: Don’t trust other people’s due diligence. Assume they have the worst possible incentives to overlook problems. Do your own due diligence from first principles.

Big bets on businesses that failed

According to the author, the accounting tricks were meant to be short-term bridges to the real new money-makers: Enron Energy Services (retail utilities) and Enron Broadband.

Enron plowed a ton of money into these businesses, in typical Enron “move fast and go big or go home.” Their read of the market and industries was wrong.

Enron’s optimistic promises to Wall Street created a situation where Enron had to deliver fast on businesses, or else their stock price would plummet.

Lesson: Don’t excuse bad practices as temporary measures until your saving grace comes around.

Complex dependencies that required progressively bigger risks or face complete failure

Enron built layers of financial dependencies in a constant push to raise stock prices. In essence, it kicked the can down the road, hoping that salvation would come at some point.

  • For example, Enron’s mark-to-market accounting might put the value of a 20-year deal down as recurring revenue in one quarter. Wall Street expected this to be real recurring revenue, which meant Enron had to book larger deals that had bad long-term prospects to keep up appearances.

Here was the nightmare scenario (that materialized):

  • Enron’s stock price was high because of misleading accounting and overoptimistic projections.
  • If Enron ever missed earnings, its stock price would fall.
  • If its stock fell, its SPE deals would unwind (since they were predicated on Enron stock prices), causing Enron to have to book massive debt on its balance sheet or issue new shares. This would cause further stock price falls.
  • This increased debt would cause a downgrade of Enron’s creditworthiness to junk status.
  • This would trigger provisions in Enron’s debt agreements to pay back loans early, and trading partners to demand cash collateral.
  • Since Enron didn’t actually have cash, its ability to pay would progressively worsen, causing trading partners to withdraw and further decrease revenue.
  • This would cause bankruptcy.

Lesson: Don’t create scenarios where you kick accountability down the road and bet on a big salvation moment. Take moves to de-risk moment to moment, and take a big write down earlier. Be even more wary if this is an existential risk, since for the sake of staying alive you might take more desperate steps.

An unwillingness to consider the worst case scenario seriously

Because of such strong incentive bias, social proof, and self-consistency bias, Enron managers refused to believe that the stock price would ever fall and trigger the nightmare scenario.

Lesson: Seriously consider the worst case scenario, and think about ways that you can mitigate this.

Bad appointments to senior managers

Generally, promoting people who had the wrong kind of ambition (more to themselves than to the fundamental health of the company).

  • Andy Fastow, known for experience creating financial structures rather than financial prudence, was promoted to CFO.
  • Ken Lay was more interested in being a public figure than in managing the business.
  • The board was weak, filled by Ken Lay with people who had reciprocal relationships with Enron.

Lesson: Hire people with the right kind of ambition, who want to grow the long-term success of the company (and are incented correctly).

Punishments for dissent/skepticism

Internally, Enron skeptics were punished for voicing discontent or blocking deals. They were reassigned to less glamorous parts of the company or publicly humiliated on their failure (like Rebecca Mark).

  • Enron partners (accountants, bankers) who voiced discontent lost the deals. Enron managers even strongly encouraged the dismissal of employees who added friction to deals.
  • Skilling had a tactic of making people feel dumb for asking questions. “All the data is out there. If you don’t get it, you’re just dumb.” Naturally, in the heady times of the dotcom boom, people didn’t want to look dumb or be wrong, in case Enron turned out to be a huge success.

Lesson: In your search for the truth, put aside the centering of your ego around being smart. If something seems too complicated for you to get, it’s probably not your fault - keep pressing.

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PDF Summary Enron's Beginning and Promise

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Enron was able to loan gas producers more money than banks, because it knew the clearing price of the gas. So producers signed contracts to supply gas to Enron, in exchange for upfront money to develop reserves. Enron could then trade the future contracts, just like oil futures.

Enron’s physical assets, ability to actually deliver gas, and its history and reputation gave it an edge over Wall St competitors who later entered the industry.

Securitization of gas lifted capital and balance sheets as constraints on growth. Selling its loans allowed Enron to eliminate debt from balance sheets and get cash to grow further.

This later became Enron Capital and Trade Resources (ECT) and by 1996 it made $280 million in EBIT, more than 20% of Enron’s earnings.

Enron International

The Enron International arm began in Teesside in the UK, with a natural gas cogeneration plant built in 1991. This plan supplied both electricity and heat to the local area. This was a successful project, prompting energy companies to ravenously seek similar deals in developing economies.

Rebecca Mark headed Enron International. Fueled by a **compensation scheme that rewarded closing deals and not...

PDF Summary Enron's Bad Practices

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Andy Fastow Brings New Convoluted Deals

In 1998, the rise of Andy Fastow to CFO brought complicated structured-finance deals that gave Enron cash that could be kept off the books. The goal of these deals was to keep fresh debt off the books, camouflage existing debt, or book earnings or cash flow. They allowed Enron to borrow money while disguising their real debt.

In summary, Enron took out large loans and made them appear like cashflow. Enron had to pay these loans back over time, but it didn’t actually have real cashflow. So it would take out further loans to pay back earlier loans. This is the corporate equivalent of starting new credit cards to pay back old credit card debt.

The types of deals included;

Special Purpose Entities

Special Purpose Entities (SPEs) are meant to be independent legal entities that fulfill a narrow objective, like purchasing assets/securitized assets from other companies. They are structured to be separate legal entities from the main firm, to protect the firm from financial risk.

Enron abused the SPE structure to inflate earnings and hide losses. In summary, Enron used these SPEs to raise debt to purchase assets,...

PDF Summary Enron Digs a Deeper Hole

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Regardless, this new TCV became the sought-after metric of the day, since it gave the appearance of Enron signing big business. As usual, Enron deal makers were given bonuses on total TCV and the projected profitability of the deal (which were wildly optimistic). Naturally, a lot of bad deals were signed very quickly.

The operational requirements of this new business put Enron out of its depth - servicing customers directly required customer service, attention to detail, and hard manual work that Enron executives referred to derisively as “butt crack” work.

Enron tried to argue that efficiency improvements would help them make the deals profitable, but soon it became clear those efficiency improvements wouldn’t pay for themselves.

Enron Broadband

In 1999, Internet stocks were overheated. Put “broadband” in your company somewhere, and the stock price would rise without tying to fundamentals.

  • Skilling calculated that every $1 invested in broadband would pay back $20 in market capitalization.

Skilling promised such large returns that the division was strongly pressured to make deals happen. They burnt a lot of money ($500MM a year) trying to find a...

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PDF Summary Cracks Start to Appear

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  • Short sellers were gaining credibility and wielding larger sticks. Investor Chanos was skeptical Enron’s broadband business could be doing so well when the rest of the industry was getting slaughtered.

More negative signs cast doubt on Enron:

  • Unclear disclosures about dealings with a related party
  • Lay and Skilling were selling shares
  • Debt was climbing when Enron was supposed to be profitable
  • No one could explain how Enron made money
  • Redeployments/layoffs were happening at the broadband business.
  • In April 2001, on an earnings call, Skilling famously called a skeptical short-seller an “asshole” for saying Enron was the only firm who couldn’t release a balance sheet or cashflow statement. Said a stunned analyst, “any CEO should be able to handle the hardest of questions from the most aggressive of shorts.”

In February 2001, an Enron accountant, Wanda Curry, saw that EES (the retail division) had over-optimistic valuations of deals and bad trades that, on inspection, actually put the division in the red by $500MM.

  • Enron’s solution was to merge the trading losses with the wholesale traders’ profits,...

PDF Summary Enron's Final Moments

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  • Prompted by these articles, the SEC began an informal inquiry into Enron’s dealings with Fastow’s partnerships. Announcement of this sank the stock 20% to $20.65
  • Oct 17: Moody’s announced it was placing Enron’s debt on review for a possible downgrade. It focused on 3 issues: negative operating cashflow, slow progress in asset sales, and more writeoffs involving Dabhol, Azurix, and broadband.
  • Oct 23: Andy Fastow was interviewed about his income from the LJM deals. The next day, Whalley fired him.

On Oct 24, 2001, Enron was unable to roll its “commercial paper,” short-term loans used for day-to-day expenses. It had no operating cash.

  • It desperately tried to make deals for cash - like opening up its books - but no one was willing to bite. It had to draw down $3 billion in backup credit lines.
  • The last-ditch solution was to sell their pipelines, the only steady cash generator Enron had left.
  • Enron’s trading also required credit to survive - trading partners would start demanding cash collateral.

Through this turmoil, Arthur Andersen began realizing how bad their work with Enron would make them look.

  • Andersen had previously paid fines for accounting...

PDF Summary The Legal Aftermath and Enron's Legacy

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  • Examples of things that should have been disclosed - EES losses being hidden in wholesale; writedowns in bad deals like Azurix; meltdown in SPEs like the Raptors; last-minute filling holes to make quarterly financials look better.
  • Furthermore, accounting rules barred a company from using its stock to boost its income statement.
  • Other things that looked bad in trial - their cashing out of lots of personal shares; extravagant lifestyles; legal settlements with many Enron employees (if nothing was wrong, why had they all settled?)

In May 2006, the jury found Skilling and Lay guilty. Lay died in July from a heart attack (some suspected he faked his death). Skilling was sentenced to 24 years in prison and a fine of $45 million.

The massive failure of Enron also spurred regulatory changes:

  • Sarbanes-Oxley increased the personal liability of CEOs for financial statements; instituted requirements for auditor independence; and increased penalties for securities fraud.
  • The Credit Rating Agency Reform Act aimed to reduce lack of competition between the big three agencies. (This didn’t kick in strongly enough in time to prevent the subprime mortgage crisis in...

PDF Summary Enabling Conditions of Enrons Deception

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  • The market seemed to justify what the business was doing - surely professional investors with billions at stake couldn’t be wrong?
  • Furthermore, skeptics within the company were publicly punished by being reassigned. For many, the risk of being punished wasn’t worth the gain from exposing wrongdoing.

Public markets

  • In a period of dotcom bullishness, the possibilities were uncapped. All sorts of companies with illusory projections were propped up.
  • Investors tolerated Enron’s opacity, since the stock was up and to the right.
  • Investors circulated a mythos of Enron being an untouchable, invincible company.

Consultants/accountants

  • Arthur Andersen’s consulting had Enron as one of their biggest customers (paying $52MM in 2000). Enron kept competitors closeby to threaten Arthur Andersen into validating their deals.
  • AA staff who grew Enron fees were promoted. Further, Enron hired dozens of Andersen accountants, giving individuals pressure to be seen by Enron as a team player.

Bankers

  • Banks earned large fees from Enron’s complicated structured-finance deals ($240 million in 1999), and bankers who grew deal sizes got...

PDF Summary Personal Traits of Enron Managers

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  • Was a weak manager, wanting others to like him and hiding behind the board for tough decisions (like not promoting Rich Kinder). Lied to keep people from getting mad at him
  • Wall Street analysts viewed him as useless and out of touch with how the business worked - they preferred Kinder who delivered the numbers.
  • Used Enron’s resources for his family (family use of company jets) and engaged in nepotism (used a relative’s travel agency to book Enron flights).
  • Became a missionary for deregulation
    • This had worked once before in natural gas.
    • He inappropriately applied this mission to retail utilities, without proof that the states were actually moving in this direction. Enron bet big and lost.

Andy Fastow, CFO

  • Burned with ambition, “not necessarily to be the best but to be seen as the best”
  • Exaggerated his resume to claim greater credit for securitization work
  • Had a chip on his shoulder by being in finance and not a department with P&L. Wanted to establish finance as a profit driver and thus sharing in the bonuses
  • A gratuitous self-promoter and brown-noser
  • Had a short temper, causing people to be afraid of speaking out

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PDF Summary Shortform Exclusive: How to Avoid an Enron

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  • Don’t use superficial markers of progress (deals on paper, valuation of deal) instead of real fundamental progress (cashflow).
  • In good heady times, don’t lose grasp on the discipline that got you there. This is when you get overconfident and make bad bets.
  • Don’t wait to bite the bullet on bad news. Avoid hoping for a bet-it-all strategy that will pay off and rescue the company.
  • Be careful doubling down on a key assumption that, if falsified, would cripple everything. In Enron’s case, they believed their stock price would never fall, allowing them to use Enron stock to prop up shaky deals.
  • Don’t avoid taking seriously the concerns of employees on the ground. Be careful of dismissing them as not seeing the bigger picture.
  • When the financial grim reaper comes, clamp down spending and appearances immediately. Don’t fly on private jets.