Enron is a name you may have actually heard before, as it's become synonymous with greed, mismanagement, and frankly rampant idiocy, if I'm being completely honest. But I doubt you know exactly why Enron is synonymous with that, at least at this point, as the incident and bankruptcy in question is over 20 years old, and it dawns on me that some of you watching this probably weren't even born yet. And that makes me feel very horrifically. Old. Now the actual inner workings of this particular scandal are actually remarkably complex, a lot more so than in other videos I've talked about when it comes to corporate mismanagement, but I'm gonna try to dumb it down as best I can so you guys kind of have an understanding of what really went wrong with Enron.
Hello, hello! Welcome to another episode of History in the Dark, I am your host, Darkness the Curse, and before we begin as always, Thank you so much to my generous patrons, my British Rail Critics, and of course my underwater train finders. You are the reason why this content remains scandalous. And today, we are indeed going to discuss the Enron scandal and bankruptcy. What led to their complete and utter meltdown.
The Enron Corporation was actually an American energy company that had their hands in a lot of different pots beyond that, though that was their bread and butter. They were initially founded by Kenneth Lay in 1985, when he merged two relatively small regional companies, the Houston Natural Gas Company and InterNorth. InterNorth actually dated back to 1930, and Houston Natural Gas that dated back to 1925. Both did specialize in natural gas pipelines, and when they combined, they were actually initially named HNG slash Internorth Inc., which is a bit of a mouthful, and even though Internorth was technically the parent company.
And their original CEO, Sam Segner, was actually originally the merger CEO, but he didn't last long. He was fired by the board of directors. and they named Kenneth Lay in charge of the company instead.
He moved their headquarters back to Houston, Texas, and, well, the first thing he wanted to do was, frankly, changing the name. They actually spent more than $100,000 on focus groups and consultants to find a new name for the company. Eventually, Enteron was suggested, which they didn't like, but they did shorten it to just Enron.
With the company's image- solidified, they began to ramp up their electric power and natural gas efforts in an effort to make more of a profit in the industry. A man by the name of Jeffrey Skilling, who at the time was a consultant at McKinsey and Company, actually was the one to suggest the idea to link natural gas to consumers in more ways, which would turn natural gas into more of a commodity. Enron's more liked the concept and referred to it as the Gas Bank, and that division succeeded quite well, which prompted Skilling to join the company as head of the Gas Bank in 1991. They also pushed into overseas operations, taking on a $56 million loan in 1989 from the Overseas Private Investment Corporation, or PIC, for a power plant in Argentina. The Gas Bank concept actually continued to make money. Basically, in a sense, they allowed gas producers and wholesale buyers to purchase gas supplies and hedge the price risk at the same time.
This put Enron in a relatively safe position, all things considered. And throughout the 90s, certain things changed for the company that not only make even more money, but also move into other industries too. Over time, they actually transitioned out of produ- producing energy themselves generally, and they wound up acting more like an investment firm, and sometimes even a hedge fund, where they would make profits off of the margins of the products that they traded in. The gas bank concept was the core operation here, and they actually changed the name eventually, because it sounded a little lame, to just Enron Finance Corporation, because Skilling pushed to not just do this with natural gas, he wanted to get into other industries too. He also hired a man by the name of Andrew Fasto- Stowe in 1990 to help out with this.
Additionally, the early 90s saw some deregulation enter the energy industry. The Energy Policy Act of 1992 resulted in Congress allowing states to deregulate their electricity utilities if they so chose, which meant that such things would be open to the free market. California, interestingly enough, this is not what I expected, did actually choose to do this.
and the result of that caused rising energy prices, but that meant more profits for the companies, and Enron was eager to get involved. In 1997, they acquired the Portland General Electric, PGE, which was actually an Oregon-based utility company, but was close enough to be able to serve the California market, which was huge. A lot of people live in California. A new division was opened up for this, Enron Energy, and they offered discounts to potential customers in California starting in 1998. They also began to sell natural gas to customers in Ohio and actually wind power in Iowa. Though their direct retail endeavor was actually cancelled in 1999, as it was costing them $100 million a year.
They weren't making any money off of it. It was probably one of the good decisions they made. They did also get into the data management industry, as the internet was becoming very much a thing, and they wanted to own their own network of lines.
In 1997, FTV Communications LLC, which was a limited liability company, formed by an N- Enron subsidiary, First Point Communications Incorporated, wound up constructing a 1,380-mile fiber optic network between Portland and Las Vegas. In 1998, Enron themselves constructed a building in a rundown area of Las Vegas, which was right over the backbone of fiber optic cables, which provided service to technology companies that were nationwide. That location had the ability to send the entire Library of Congress anywhere.
anywhere in the world within minutes, as the company stated, and could actually stream video to the whole state of California. Basically, for late 90s standards, it was state of the art. However, naturally, Enron had a scheme in this. They were looking to make money, because of course they were, and what they wanted to do was trade bandwidth, like they traded oil, gas, and electricity.
Basically, how they handled everything else is the way they wanted to handle the transfer of information, and they lost an operation. to build a ridiculous amount of fiber optic transmission capacity in Las Vegas, which was part of their evil scheme to basically own the internet, which was very forward-thinking of them if they could pull it off. What they really wanted in the end was to have all U.S. internet service providers rely specifically on their Nevada facility to supply them bandwidth.
Enron would sell that bandwidth to those companies in a similar fashion to their other commodities. Thank you. Now regardless of what you think of their business practices, the point was that from the outside looking in, Enron was a very dominant force. They were exceedingly wealthy, and to everyone around them, seemingly making just a ton of money, all the money, a ludicrous amount of money. But this wasn't quite right, especially during the late 90s.
See, behind the scenes, Enron was cleverly disguising a lot of their losses, because they actually weren't as successful as everyone thought they were. Even though they were the largest seller of natural gas in North America by 1992, some of their other avenues to try to make more money didn't pan out quite like they planned, but they didn't actually tell anyone that. Even though legally, of course, they should.
Shareholders need to know what a company's doing at any given time because they have a stake in it. That's how the stock market works. Once you buy a share in a company, you are an investor, and therefore, you have to know how the company's doing, and that requires the company to know how the company's doing. to be honest with you, and it is indeed illegal to hide such things from investors.
And by doing this, they actually drove up the price of their own stock because everyone thought they were super successful. And at first, they weren't necessarily doing that too much, if at all. And between 1990 and into 1998, during that whole time, their stock price only raised by 311%. Now that's a good increase, that's great in fact, but it's only slightly higher than the average rate of growth in the state.
standard and poor 500 index. So they were just looking like they were seeing success. Not overwhelming success, but success.
But in 1999, their stock spiked all of a sudden by 56%. Remember, the 311 was over the course of seven years. 56% in just one year is absurd.
And in 2000, it rose up by 87%, which is insane. By December 31st, the year 2000, their stock was priced at $83.00. and 13 cents a share and the company's market capitalization exceeded 60 billion dollars, which was actually 70 times their own earnings and six times their book value, which isn't unheard of because it only showed that the stock market, basically the shareholders, had very high expectations about their future prospects, which again, from the outside looking in, did look really good.
And they were even rated the most innovative large company in America in Fortune's Most Admired Companies survey. But like I said, There was a lot going on behind the scenes that people just didn't know until it was far too late. In order to fully understand where Enron went wrong here, you first need to realize what revenue recognition is. It's a principle, and it's actually a cornerstone of accrual accounting, together with what's known as the matching principle. Both of these determine the accounting period in which revenues and expenses are recognized.
Basically, it's the timing of everything. When do you say something made you money? When do you say something loses you money? That's basically it in the simplest of terms.
To dumb it down for everybody, let's say you're buying, I don't know, a bag of chips. Under revenue recognition, you acknowledge the financial loss when you pay for the bag of chips. You give the cashier your money, they take your money, that is less money for you, but you do gain a bag of chips.
So under the principle, you can acknowledge that you have gained an asset of a bag of chips. It's not quite that simple, obviously, but that's basically what I'm trying to say. According to the principle of revenue recognition, revenues are recognized when they are realized, or realizable, and are earned no matter when cash is received.
So effectively, under the principle, you can account for a significant gain if you have a contract with someone to, say, pay you a million dollars. They may not have physically given you a million dollars just yet, but since that is in writing, and they owe you that money, and they have... have to legally pay you that money, and you know that, you can look ahead and know you're going to receive that money, and it would be factored under accrued revenue. Accrued revenue is revenue that is recognized before cash is received. But you can- can recognize that the cash is coming.
Let's take the bag of chips example again. Let's say you want a bag of chips, and you order it from DoorDash. Now, you suffer the immediate loss of paying for said bag of chips via DoorDash, and I don't know why you would ever do that. It's really expensive.
Please do not. That is poor financial management. Walk to the corner store. Goodness. Anyway, but you know you're going to get that bag of chips.
You can therefore say that that is accrued, well, not revenue, but chips, an accrued asset. You know you're going to get it. You see what I'm saying?
I'm trying to say. Anyway, I bring this up because Enron earned profits by providing services such as wholesale training and risk management on top of building and maintaining electric power plants, natural gas pipelines, storage, as well as processing facilities. That's all well and good, but... When accepting the risk of buying and selling products, merchants are allowed to report the selling price as revenues and the product's costs as cost of goods sold. This is relevant because an agent is different than a merchant.
An agent provides a service to a customer, but does not take the same risk as a merchant for buying and selling. Service providers, when they are classified as agents, may report trading and brokerage fees as revenue, but not for the full value of the transaction. Other trading companies like Goldman Sachs used the conventional agent model for reporting revenue, which is where only the trading or brokerage fee would be reported as revenue, because that's the only revenue they were getting at that point. That makes sense.
Enron, on the other hand, decided to report the entire value of each of its trades as revenue. That's a merchant model, and it was considered much more aggressive in the accounting sense than the agent model. Their method of reporting actually inflated trading revenue, and it was later adopted by other companies in the energy trading industry in an attempt to stay competitive with Enron's large increase in revenue.
Between 1996 and 2000, Enron's listed revenues increased by more than 750 percent, rising from $13.3 billion in 1996 to $100.7 billion in the year 2000. 2000 that was an expansion of 65% per year which is ridiculous for pretty much any industry the energy industry for example Generally considered growth of two to three percent per year Very respectable, that was considered good. But Enron's revenue increases were just unheard of. And for just the first nine months of the year 2001, Enron reported $138.7 billion in revenue, which placed them at the sixth position on the Fortune Global 500. But again, on the back burner, Enron was messing around. They used creative accounting tricks, and on top of that, purposefully misclassified loan transactions as sales close to quarterly reports. reporting deadlines.
Another practice we have to look at is mark-to-market accounting, which is accounting for, well, the fair value. value of any asset or liability based on the current market price or the price for similar assets and liabilities. It's a fairly simple concept, though it can get complicated, and on paper it's generally a very good policy.
It helps determine the value of any asset or value of things back to your bag of chips how much did you pay for that bag of chips was it the dollar what about the other stores did they also sell it for a dollar well they did it's all a dollar oh good that would be your fair value of a bag of chips because the market has determined that that is how much people are willing to pay for said bag of chips. The company still makes a profit, and you don't feel super bad about using a dollar for a bag of chips. Well, now what I think about with inflation of bag of chips is probably way more than a dollar by now, but it's just an example. Okay, so in Enron's natural gas business, their accounting there had actually been pretty straightforward. For each time period, they listed actual costs of supplying the gas, and actual revenues received from selling the gas.
That makes sense. However, when Skilling joined the company, he demanded that the trading business adopt mark-to-market accounting, following his belief that it would represent the true economic value. As a result of that change, they became the first non-financial company to use the method to account for their complex long-term contracts.
Mark-to-market accounting required that once a long-term contract had been signed, income is estimated as the present value. of net future cash flow. Now, the obvious problem with this situation is that they never really knew how much profit was going to be generated by any of these deals. Like, they could kind of guess, but it was just that, a guess. And often their guesses were way off, overestimating deals as much more valuable and lucrative than they turned out to be.
Some didn't net them any money. Some, in fact, lost them money, and yet they were still listed as having given them money. them money because of the way they'd been calculated. And because of that, investors were sometimes given misleading or sometimes just outright false reports. Income from projects could be recorded, even though the firm might never have actually received any money.
And that income compounded over time, increasing financial earnings that were on the books, but their literal earnings were not at all close to what was on the books. And another compounding issue with this is that Over time, they had to keep developing newer and better deals to show proper growth. They had grown, on paper, too much early on, and they kept having to build on that growth to make the investors think they were doing really well, when in reality, they really weren't doing so hot.
And had they not lied on the books, they probably would have remained stable, like they'd probably still be around now. One of Skilling's greatest faults as a corporate leader was that he was ridiculously focused on pleasing shareholders. That's all he cared about.
Now, that may not sound super unusual to you, but sometimes you have to accept that your company's going to take a financial loss and report that honestly to your shareholders. Your stock price will take a hit, but that's just a normal part of doing fair business. In Skilling's case, he was intent, constant in his obsession to make sure the shareholders believed the company was doing really well, just all the time, and if he had to basically lie to make sure that happened, then that's what he was gonna do, even if some of their deals never panned out with anything. For example, there was one contract that was signed in July of 2000 between Enron and Blockbuster Video.
They signed a 20-year agreement-Hahahaha You know, it doesn't matter what happened to Enron, even if they were still around, this would not have gone well either way. Anyway, they signed a 20-year agreement to introduce on-demand entertainment to various U.S. cities by the year's end. Actually, that's- basically an old school streaming service, maybe that would have gone well. And after several pilot attempts, Enron wound up claiming profits of more than $110 million.
But that network, at least at the time, actually failed to function properly in practice. So Blockbuster wound up with- withdrawing from the contract, but Enron continued to claim future profits, even though the deal had obviously resulted in a financial loss, and there wouldn't be any future profits because the whole deal was off. But how in the heck were they hiding all these losses?
They couldn't have lied all the time. Someone would have had to have known that Enron was in debt. I mean, heck, if they were in debt, their debtors would have known, and would have also known that Enron was apparently making all this money, yet not paying them. Like, someone had to have asked a question about that, right?
... Well, that involved another clever trick to avoid problems, known as special purpose entities. A special purpose entity, or SPE, is a legal entity that's created to fulfill very narrow, specific... or sometimes just plain temporary objectives.
They're generally used by companies to isolate themselves from financial risk. Sometimes these are called shell companies, and Enron disclosed very minimal details on how they were using the SPEs. Those companies were created by a sponsor, but funded by independent equity investors and debt financing.
For financial reporting purposes, a series of rules dictate whether a special purpose entity is a separate entity from the sponsor. By 2001, Enron had used hundreds of SPEs, hundreds of shell companies, to hide their own debt. In Enron's case, the SPEs were essentially what are known as Tabashi schemes.
It's a financial fraud through creative accounting where a client's losses are hidden by an investment firm, by shifting them between the portfolios of other clients. As a result of all this subterfuge, investors had no idea how much debt Enron was in. In fact, Enron may not have even known how much debt they were in, because they were hiding it in all these other companies.
The methods involved in dealing with the shell companies are oddly specific, so I'll talk about a few examples right now to try to give you a better idea of what was really going on here. In 1993, Enron actually established a joint venture in energy investments with CalPERS, which was the- California State Pension Fund, which they both refer to as the Joint Energy Development Investments, or JEDI. Yes really.
In 1997, Skilling, who was serving as Enron's COO at the time, asked CalPERS to join Enron Enron in a separate investment. Kalpers was interested, but only if it could be terminated as a partner in the whole Jedi thing. But Enron didn't want to show any debt from assuming Kalpers'stake in Jedi on their own balance sheet.
So Fasto, who was the CFO of Enron, developed a special purpose entity known as Chuko Investments, a limited partnership, or LP, which raised debt guaranteed by Enron, and was used to acquire Kalpers. Cowper's joint venture stake for $383 million. Because of Chuko, Jedi's losses were kept off of Enron's balance sheet specifically.
They were on Chuko's. Another one of these SPEs was known as White Wing. In December of 1997, with funding of $579 million provided by Enron and $500 million from an outside investor, White Wing Associates, LP, of course, was formed, and two years later, the entity's arrangement was changed so that it would no longer be consolidated with Enron, and therefore be counted on the company's balance sheet.
Whitewing was used to purchase Enron assets, including power plants, pipelines, stocks, and other investments. Whitewing bought assets from Enron that totaled $2 billion in value, using Enron's own stock as collateral. Although the transactions were approved by the Enron board, the asset transfers were not true sales and should have been treated instead as loans, not profits, because they were basically buying stuff off of themselves. Then there were the LJMs, or Lee Jeffrey Matthews.
In 1999, Fusto formulated two limited partnerships, LJM- Cayman LP and LJM2 Co-Investment LP for the specific purpose of buying Enron's own poorly performing stocks and stakes to improve their own financial statements. Both of the LJMs were created specifically and only to serve as the outside equity investor needed for the special purpose entities that were being used by Enron. Festo actually had to go before the board of directors to receive an exemption from Enron's contract. Code of Ethics. In order to manage these companies, the partnerships were funded with around $390 million provided by investors, and related SPEs around LJM were known as Raptors 1 through 4, named after the Velociraptors in Jurassic Park.
Yes, seriously. You're just screwing around at this point. Enron gave the Raptors more than $1.2 billion in assets, including millions of shares of Enron common stock and long-term rights to purchase millions more in shares.
plus $150 million of Enron notes payable, as disclosed to the company's financial statement footnotes. The SPEs had been used to pay for all of this, using the entity's debt instruments, and Enron actually capitalized on the wrapped- in a manner very similar to the accounting employed when a company issues stock at a public offering. Then they booked the notes payable issued as assets on its balance sheet, while increasing the shareholders'equity for the same amount. That decision actually would later become an issue for Enron as well as their own auditor, the Arthur Anderson firm, as removing it from the balance sheet resulted in a $1.2 billion decrease in net shareholders'equity. Basically, too long, didn't listen, Enron was shifting stuff around and almost buying things from themselves or investing things into themselves using more investor money, all in an effort to make Enron specifically look very good.
while all their SPEs didn't wind up looking so hot, but that didn't matter because they looked good to investors. Even though all this was really being done with mostly their own money, like yeah, they were taking investor money, but not enough to cover all this, and not enough to sustain the lie over time. But did anybody on the board at any point during the years this was happening actually say, hey, maybe, maybe, maybe we should not do this anymore?
Did someone say, that? Well, no, not as far as we know. And even if someone thought of it, they really didn't have much of a reason to, as long as they weren't making any direct decisions and couldn't be implicated in what was basically turning into a complete scam.
Because, on paper, Enron should have had a model board of directors that was comprised mostly of outsiders with significant ownership stakes and a talented audit committee. In fact, in its 2000 review of best corporate boards, the chief executive executive business magazine included Enron among their five best boards. But again, behind the scenes, there was a lot of mischief going on, and what they were doing wasn't sustainable.
They went through with it, because while Enron's compensation and performance management system was actually designed to retain and reward its most valuable employees, the system actually, in practice, contributed to a very dysfunctional corporate culture that wound up becoming much more obsessed with short-term... earnings to maximize their own bonuses rather than long-term goals and long-term sustainability for a company which by the way the latter two things are way more important in business generally you want your company to last for years and years because the longer it lasts the more money it's gonna make and this wasn't just the board it went down to even the lowest level employee because what they wound up doing was basically constantly try to start deals just the deals having the deals saying they had the deals. The deals, the deals, the deals, but completely disregarding whether or not those deals were actually, you know, good, whether or not they could actually turn a profit out of it, it was just that they made a deal, which would mean they'd get a better rating for their own performance reviews.
Accounting results were recorded as soon as possible to keep up with the company's stock price, which meant, back to what I said before, they were listing profits from deals that never turned out any money, and sometimes lost the money. But the effect was that the deal makers and the executives received large cash bonuses and stock options because, well, they made the deals. Enron was constantly pushing its own stock price, emphasizing it in fact, and management was compensated extensively using stock options, which isn't unheard of.
A lot of U.S. companies do that, but that policy of stock option awards caused management to create expectations of rapid growth in efforts to give the appearance of reported earnings to meet Wall Street's expectations because they themselves had a lot of stock, they wanted that price to go up by whatever means necessary. They even installed stock tickers in their lobbies, elevators, and on company computers so everyone could see the company's stock at all times, which is a little obsessive. And at budget meetings, Skilling would often develop the target earnings by simply asking, what earnings do you need to keep our stock price up?
And that number would be used even if it wasn't feasible for the company to actually do that. Skilling felt that if But if Enron employees were constantly worried about the cost of how to do a deal in the first place, it would hinder original thinking. So extravagant spending was also just the norm around the company, especially with the executives. Employees had large expense accounts, and many of the executives were actually paid twice as much as Enron's competitors. It wasn't as if Enron was completely stupid.
They were looking into risk management. They were actually praised for their sophisticated financial risk management tools, which you'd think would tell them that what they were doing was bad, and the process was crucial to them. because of the way they did business. Enron established long-term fixed commitments, which had to be hedged to prepare for the invariable fluctuation of future energy prices.
The downfall wound up being attributed to to their use of derivatives and the SPEs. They hedged their own risk with the SPEs, which they also owned, which meant that they retained the risk associated with those transactions. They weren't actually shooting themselves from things legitimately going wrong, they were just- just hiding it when things did go wrong. Basically, they implemented hedges with themselves.
Their aggressive accounting practices were known to the board of directors. The problem was that most of the board actually didn't have much experience with derivatives, or the SPEs, to really understand what they were being told whenever, say, Fastow asked to make another one. As a result to them, it seemed like business as usual. Not all of them realized how deep this went, or how badly it was going to screw the company up. Then there was also their own accounting firm, Arthur Anderson.
They were accused of applying reckless standards in their own audits because of a conflict of interest over the fact that Enron was paying them quite a lot of consulting fees. Anderson earned $25 million in audit fees and $27 million in... million in consulting fees. The auditor's methods were questioned as either being completed solely to receive their own annual fees or for their lack of expertise in properly reviewing Enron's revenue recognition, special entities derivatives, and other accounting practices. Enron had actually hired numerous certified public accountants as well as accountants who had worked on developing accounting rules with the Financial Accounting Standards Board, FASB.
Now, why would they do that? Well, that's because they wanted accountants with significant knowledge of what was known as the Generally Accepted Accounting Principles, or GAAP, which was the accounting industry's standard. They tried to use the literature in GAAP to their own advantage, finding as many loopholes as they could and exploit weaknesses in it to make Enron look that much better. And Anderson's auditors were actually pressured by Enron to defer recognizing the charges from the SPEs as its credit risks became known.
Since the entities would never actually turn a profit, and they knew that, accounting guidelines did require that Enron should take what was known as a write-off, which means the value of that entity was just removed from the balance sheet and factored in as a loss. That makes sense. But Enron didn't want any losses on their sheets, so to pressure Anderson into meeting expectations, they would occasionally allow accounting companies Ernest & Young or PricewaterhouseCoopers to complete their business. accounting tasks to create the illusion of hiring a new company to replace Anderson.
Anderson was so terrified of losing the contract because it made them a lot of money that they would often be much more receptive to Enron's requests. Enron's internal audit committee would meet only a few times a year and was fiercely criticized for their very brief meetings that would also cover large amounts of material in a very, very short amount of time. Actually, it was basically like this YouTube video.
Enron also made it a habit of booking costs of cancelled projects as assets. Which, no, those are cancelled projects. That's the opposite of an asset.
What? But their rationale was that no official letter had stated the project was cancelled. So, I mean, it could be put back into, you know, it might be a thing.
You don't know. No, no, we know. It's cancelled.
Write it off. And other more literal points of deception were used. Analysts were actually given a tour of the Enron Energy Services office in 1998, and they were super impressed with how the employees were working this- vigorously.
There were a lot of employees just running around doing so much work. It was awesome, awfully showing how busy Enron really was. But secretly, Skilling had ordered certain employees to the office from other departments and instructed them to just pretend to work hard, to make it look like the division was much larger than it actually was. This ruse was used several times to throw analysts off their scent.
And last but certainly not least, there were, of course, Of course, they're speculative business ventures. Enron had a division known as Azurix, slated for an IPO, or Initial Public Offering, or stock launch, that had planned to bid between $321 million and $353 million for the rights to operate water system services for areas around Buenos Aires in Argentina. That was at the high end of what Enron's risk assessment and control group actually did advise.
But there was so much pressure to win the deal that Zurich's executives decided to up their bid like morons. And they wound up bidding $438.6 million for this contract, which wound up being twice as much as the next highest sealed bid. Basically, they did not have to bid that high and waste that money for no reason.
And this got worse when Enron executives arrived at the Argentinian facilities, as they found them in complete shambles.. with all of the customer records completely destroyed. Basically, they'd have to rebuild everything, costing them even more money. It was a total disaster. But Enron hid that too, as they did attempt to hide every single one of their screw-ups.
But they couldn't do this forever. The company was hemorrhaging money, secretly. No one knew it at the time, but they were.
The downfall actually began with a reporter at the Wall Street Journal Bureau in Dallas, Texas. On September 20th, the year 2000, a story broke about how mark-to-market accounting had become very prevalent in the energy industry. He wound up noting that outsiders had no real way of knowing the assumptions on which the company's that used Mark to market base their own earnings.
That story only appeared in the Texas Journal, but short seller Jim Chanos actually wound up reading it and decided to check Enron's 10k report for himself. Now as a short seller, Jim has a lot more experience in stocks than most people. Jim's whole thing is stocks, he analyzes numbers, that's what he does. And Chanos thought it was really weird that Enron's broadband unit appeared to far outpace a then troubled broadband industry.
In the late 90s and early 2000s, internet was still trying to get off the ground, and it wasn't going as smoothly as ever one thought it would. That was unanimous across the entire market, except where Enron was concerned. He then also noticed that Enron was spending much of its invested capital, and was actually alarmed by the large amounts of stock being sold by insiders.
Because he is a short seller, and will profit if a value of an asset falls. In November of 2000, he decided to short Enron stock. In February 2001, the CAO, Chief Accounting Officer, Rick Causey, told the budget managers, from an accounting standpoint, this will be our easiest year ever. We've got 2001 in the bag. Okay.
On March 5th that same year, Bethany McLean published an article in Fortune called Is Enron overpriced? Which questioned how Enron could actually maintain their high stock value, which was trading at 55 times their own earnings. And she argued that analysts and investors didn't actually know exactly how the company made their money.
Chanos had actually been the one to suggest to her that she view the company's 10k for herself. She found strange transactions, an erratic cash flow, And huge debt that only showed once you really crunched the numbers down yourself. That was the biggest red flag to her, as she wondered how a profitable company could be adding debt at such a rapid rate.
It didn't make any sense. McLean chose to contact Enron directly, and telephone Skilling to discuss her findings prior to publishing her own article. She talked to them first, giving them a chance to explain themselves before she did something that could damage their reputation. But...
But Skilling didn't want to talk to her. He called her unethical for not properly researching his company. Fastow had claimed that Enron could not reveal earnings details, as the company had more than 1,200 trading books for assorted commodities, and did not want anyone to know what's on those books. We don't want to tell anyone where we're making money. That sounds really sus.
Fastow. Fastow. That's something a drug dealer says.
Let's not know that. I would really like to know where you're making money now. In a conference call on April 17th, 2001, Skilling, who was in the CEO of the company, verbally attacked Wall Street analyst Richard Grubman, who also questioned Enron's unusual accounting practices. And as time had passed, a number of very serious concerns wound up being in Enron's face. They'd recently faced several serious operational challenges.
Logistical difficulties, for example, in operating a new broadband communications trading unit, and the losses from constructing the Davhole Power Project, which was a large gas-powered power plant in India that had been controversial from the beginning as it was high-priced and they may have done some bribery at the higher levels of things. On August 14th, 2001, Skilling actually announced that he was resigning from his position as CEO after only being in that spot for six months, citing personal reasons. But observers noted that in the months before he left, Skilling had sold, at minimum, 450,000 shares of Enron, at a value of around $33 million. That's sus. Kenneth Lay, who was serving as chairman...
assured market watchers that there would be no change to the performance or outlook of the company going forward from the departure of Skilling. And Lei announced that he himself would reassume the position of CEO. Everything will be fine, no worries. However, all this stuff compounded and actually caused Enron's stock price to fall.
Investors were losing confidence in them because they They still weren't willing to tell them where they were making their money. The plot twist, they weren't making money. That was the secret. And in October, they announced their intention to begin the process of selling their lower-margin assets in favor of core businesses of gas and electricity trading.
That policy wound up including selling Portland General Electric to another Oregon utility, Northwest Natural Gas, for about $1.9 billion in cash and stock. On October 16, 2001, Enron announced... announced that restatements to its financial statements for years 1997 to 2000 were necessary to correct accounting violations. Really, you don't say? Those restatements for the period reduced earnings by $613 million, 23% of reported profits, increased liabilities at the end of 2000 by $628 million, reduced equity by the end of 2000 by 1.2 billion, billion dollars.
And additionally, in January, Jeff Skilling had asserted that the broadband unit alone was worth $35 billion, but no one really believed that. Enron's management team wound up claiming that the losses were mostly due to investment losses, along with charges, such as about $180 million in money spent restructuring the company's troubled broadband trading unit. Lei made a statement, saying that they were doing this to clear away issues that clouded the performance and earnings potential of our core energy.
businesses. But analysts were very unnerved, as if this was Enron still hiding something, I mean, it already looked really bad. Does that mean this was worse? Fastow wound up disclosing to Enron's board of directors on October 22nd that he personally earned $30 million from compensation arrangements when managing the LJM limited partnerships.
That same day, the share price of Enron decreased from $20.65 down to just $5.40 in one day. That's a horrific drop. And that happened after the announcement that the SEC, the U.S.
Securities and Exchange Commission, mission was investigating them. Investors don't like hearing that. The SEC only looks into companies if they really have sufficient evidence that something sketchy is going on. On October 25th, Fastow was actually removed as CFO, even though Lay had told him just the previous day that he and the board had confidence in him.
But the move only happened after several banks refused to issue loans to Enron unless Fastow was removed. Skilling and Fastow were now both out. out of the company, but some analysts thought that would make revealing the company's practices a lot more difficult.
Enron stock was also now trading at $16.41. It went up when they removed Festo, but not by a lot. Jeff McMahon succeeded Festo as CFO, and his first task was to deal with their own cash crisis.
Just the day before that, Enron found out that they couldn't roll their commercial paper, which is an unsecured promissory note with a fixed maturity of rarely more than $270. days. It's like an IOU. That meant they lost access to several billion dollars in financing.
The company had actually experienced difficulty selling their commercial paper for about a week, but now they couldn't sell even overnight paper. On the 27th, they began buying back all their commercial paper, valued at $3.3 billion, in an effort to calm investor fears about Enron's supply of cash. Enron financed that repurchase by depleting their lines of credit at several different levels.
banks because they didn't actually have the money, so they had to use credit. While the company's debt rating was still considered investment grade, its bonds were trading at levels slightly less, making future sales really problematic. Most people wouldn't trust that. Then it was discovered that Festo had been so focused on creating off-balance sheet vehicles, the SPEs basically, that he'd been completely ignoring some of those basic parts of corporate finance.
McMahon and a team tried to put together a way out of the cash crisis. and discovered that under Fastal's watch, Enron was operating on a quarterly basis. Fastal never developed procedures for tracking cash or debt maturities that were common for companies of Enron's stature.
Without that, the company just didn't know a lot of aspects about its own financial situation. He wasn't reporting it properly and was hiding things in the stupid SPEs, like an idiot. By the end of the month, their main short-term danger was was their credit rating, which was currently going down quickly.
They'd already been slated for a review for a possible downgrade by Moody's and Fitch, which were two of the three biggest credit rating agencies. That downgrade would force Enron to issue millions of shares of stock to cover loans that they had personally guaranteed, which would therefore decrease the value of existing stock even further. And because of the media circus surrounding the company's situation, many Many of companies that had contracts with them began reviewing those contracts, especially the long-term ones, in the event that Enron's rating were lowered below investment grade, which was a possible hindrance for future transactions.
Enron had been hiding their finances with very vague and cryptic statements, so most analysts and observers had trouble interpreting a lot of it. You really had to be an expert in the numbers to get even a basic understanding of how bad Enron was getting. Some felt that no one had ever been able to get the money they wanted.
Enron, besides skilling in Fasto, could completely even explain those years of mysterious transactions. Even Lei had to admit, in late August of 2001, that he really didn't fully understand what those two had been up to. On October 29th, news broke that Enron was seeking a further $1-2 billion in financing from various banks. But just the following day, Moody's lowered Enron's credit rating from BAA1 to BAA2, which is just two levels above junk status, which means exactly what you think it does. In the beginning of November, the SEC was now pursuing a formal investigation, and Enron's board announced that they would commission a special committee to investigate the transactions.
Sources claimed that Enron was planning to explain its business practices more fully, and their stock was now trading at an amazing $7 a share. And by that point, given their size, that was deplorable, and they obviously couldn't stay independent, so they began searching for someone to buy them out. They received a lot of rejections, because no one wanted to touch them, but another energy trader that was actually based in Houston, an arrival of theirs, Dyna-G was actually a bit more resensitive to the possibility, since they would be eliminating a direct competitor if Enron was gone. The price was actually pretty manageable by them. It was considered very low, just $8 billion in stock, not even cash.
And the board voted to acquire them on November 7th. Chevron Texaco, which actually owned about a quarter of Dyna-G, agreed to provide Enron with $2.5 billion in cash. Specifically, $1 billion at first and the rest when the deal was completed. Dyna-G would be required to assume... nearly $13 billion in debt, plus any other debt that would be found later as the SEC tore apart Enron's secretive business practices.
Which could be as much as $10 billion in hidden debt. The deal was confirmed on November 8th, 2001. That sounds like a lot of risk for Dainiji, but the deal was mostly on their terms, as Enron was not in a position to negotiate. They needed help, and they needed it now, so whatever Dainiji wanted, they were okay with.
That's probably why they went for 8 billion in stock. And this wasn't a merger, it was a buyout. Dainiji would be the surviving company, and Enron's shareholders would get a 40% stake in the enlarged version of that company. Enron would get three seats on the merged company's board. Lei himself would not be given a management role.
though it was believed he would get one of Enron's seats on the board. This deal wound up being pretty much the only thing keeping them alive throughout November, as Enron couldn't afford to pay their bills, and Enron wanted to keep as much cash around in the event of a possible bankruptcy. The deal allowed Enron to keep their credit at investment grade, because had that changed, with Enron being reduced to junk status, their ability to trade would be very limited, and there would be a reduction or elimination of their credit lines with...
competitors. They were still at risk though, but Enron and Dynagy retooled the deal to make it harder for Dynagy to trigger the material adverse change clause and pull out of the arrangement. That caused both Moody's and SMP to drop Enron to just one notch above junk status, but not actually at junk status.
That let Enron pay their bills one day late with interest. Both companies promoted the deal aggressively, and some observers started to be hopeful of the idea, but credit issues were becoming much more critical. Around the time the buyout was made public, Moody and SMP publicly announced that they had reduced Enron to just above junk status, and SMP later admitted that if it weren't for the deal, Enron would be in junk status. It was also revealed that Lay and other officials had sold hundreds of millions of dollars worth of stock during the months prior to the crisis, almost like they knew something was gonna happen, and Lay stood to receive a payment of $6,000.
million as a change of control fee subsequent to the Dynagy acquisition, while many Enron employees had seen their retirement accounts, which were based largely on Enron stock, completely evaporated. This caused the lower-level employees to deeply resent the higher-ups, which is a story we've heard often enough, but it was much worse here. But with all this going on, the Wall Street Journal actually expressed doubts that Dynagy would even proceed with this deal at all, or bare minimum it needed to renegotiate the whole thing. Enron would actually reveal in a 10Q filing that almost all the money they had recently borrowed for purposes, including buying its commercial paper, or about $5 billion, had been exhausted in just 50 days.
They spent $5 billion, billion, with a B, in 50 days. What? Everyone was horrified by that, especially considering Enron was still in debt. How much debt did you have?
And Dynagy was... reported to have been completely unaware of Enron's rate of cash use. And by this point, in order to end the proposed buyout, Dynagy would have to legally demonstrate a material change in the circumstances of the transaction as late as November 22nd, and they began to have serious revelations about the whole thing.
Lei had assumed that one of his subordinates had actually shared the 10Q with Dynagy, but no one at Dynagy actually saw it until the thing went public, and then it emerged that Enron's traders had actually grabbed money much of the money from Dynagy's cash infusion and use it to guarantee payment to their trading partners when it came time to settle up. The SEC then announced that it had filed civil fraud complaints against Anderson. A few days after that, sources claimed that Enron and Dynagy were renegotiating the terms of their arrangement. Dynagy was now demanding Enron agree to be bought for just $4 billion, rather than the previous $8, and that's in stock, remember. With all this collapsing, the credit rating agencies had had enough, and on November 28th, 2001, they reduced Enron's credit rating to junk status, and Donaghy's board tore up the merger agreement, and Enron's stock price fell to 61 cents.
at the end of that day's trading. Enron's creditors and other energy trading companies suffered the loss of several percentage points. Some analysts felt their failure indicated the risks of the post-September 11th economy and encouraged traders to lock in profits where they could.
The question now became of how to determine the total exposure to markets and other traders to Enron's failure. Within 24 hours, speculation was just all over the place that Enron would have no choice but to file for bankruptcy. And on December 1st, the speculation came true, as the entirety of Enron filed for Chapter 11 bankruptcy protection. At the time, it was the largest bankruptcy in U.S. history, surpassing Penn Central.
Although it's worth mentioning that Enron would actually be surpassed just the following year by WorldCom, and that resulted in 4,000 lost jobs. Thousands of employees were told to pack their belongings and given 30 minutes to vacate the building. 62% of the 15,000 employee savings plans relied on Enron stock that was purchased at $83 in early 2001, but now it was worth pennies.
Their retirement plans were effectively gone. On January 17, 2002, Enron dismissed Arthur Anderson as their auditor. signing their accounting advice and the destruction of documents.
But Anderson countered that they'd already ended its relationship with the company when Enron became bankrupt, and it would come out that Enron was the ones pressuring them into looking the other way in certain aspects. As their ridiculous practices came out through the investigation, it was eventually decided it was appropriate to file criminal charges against certain high-up officials, since what Enron had been doing in many ways was illegal. They were hiding things from their investors, making themselves look better than they were, and when it came crashing down, many of them sold their stock and ran for the hills. Jeffrey Keith Skilling was charged with conspiracy, securities fraud, false statement, and insider trading. He was originally sentenced to 24 years in federal prison, later reduced to 14 years and a $45 million fine.
He was released on February 21, 2019. It was actually reported to be trying to gain funds to launch an online oil and gas trading platform named Veld LLC. Okay, on August 30th, 2022, the company was listed as withdrawn. Yeah, I wonder why no one trusts you. Andrew Fastow was charged with conspiracy, wire fraud, securities fraud, false statements, insider trading, and money laundering.
His wife Leah, who also worked for Enron, was also charged with conspiracy to commit wire fraud, money laundering, and filing fraudulent income tax returns. Leah would only remain in prison for about a year. Andrew- Andrew would stay there for six years, followed by two years of probation.
These days, he actually works in public speaking, with presentations on ethics and business. Really? You do? Well, in his defense, he is using his platform to try to make amends for what he had done. As he put it, I tried on every way I could to technically comply with the rules, but what I did was unethical and unprincipled, and it caused harm to people.
For that, I deserved to go to prison. He's actually been doing that for quite a long time, and seems to be doing alright, at least in an effort to change his image. And as for Kenneth Lay, well he was charged with 11 counts of securities fraud, wire fraud, and making false and misleading statements. He was actually put on trial alongside Skilling, and though he was found guilty, he actually died before he could be sentenced on July 5th, 2006, suffering what seemed to be a heart attack. So you might say he got away with it.
with it. Many other lawsuits were also filed, particularly from Enron employees, who filed a class action lawsuit alleging mismanagement of their 401ks. Since it was all based on stock, the fact that Enron had manipulated their own stock to make it seem better was also misleading their own employees in reference to their own retirement plans. They actually won the suit for $85 million, but that was in compensation for $2 billion that was lost from their pensions. and from the settlement, each individual employee received just $3,100, which is hardly retirement money, but it's better than nothing, I suppose.
And investors also reached settlements, because Enron ripped off a lot of people, but the one thing they really did wrong, and really did wrong, and you need to stress this, I need you to know this, understand something. Do not anger the money men. Do not lie to these people. These are the dudes that are going to find you, and make you pay for working the money.
over, because they might have gotten away with it had they stopped early, but the issues kept compounding over and over again for years, and it also resulted in what was known as the Sarbanes Oxley Act. The Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial Services held multiple hearings about the scandal, and that led to the passage of the act on July 30th, 2002. It's nearly a mere image of an Actually, the act established the public company accounting oversight board to develop standards for the preparation of audit reports, the restriction of public accounting companies from providing any non auditing services when auditing provisions for the. independence of audit company committee members and executives being required to sign off on financial reports as well as the relinquishment of certain executives bonuses in case of financial restatements and expand financial disclosure of companies'relationships with unconsolidated entities.
The SEC also recommended certain changes of the stock exchange's regulations. The final proposal that went into effect included that all companies must have a majority of independent directors. Independent directors must comply with an elaborate definition of independent directors. A compensation committee, nominating committee, and auditing committee shall consist of independent directors.
All audit committee members should be financially literate. and one member of the audit committee is required to have accounting or related financial management expertise and the board should hold additional sessions without management. Enron is no longer an icon of the energy industry but as the mascot of corporate failings as well as cover-ups.
It wasn't even just that they mismanaged themselves. They did but they did it in the dumbest of ways in an effort to drive up their own stock price which doesn't help long-term sustainability. Having a high stock price is great, but you also need to be making money, like, actually having services, and actually having those services make money.
Enron lost the plot when it came to that. They stretched themselves too thin, but pretended as if they were growing, pretended as if they were profiting. They told the shareholders, in a variety of ways, to make them keep investing their money, and things snowballed and compounded from there, resulting in accrued debts, and a situation that it was impossible for any real company to do. company to dig themselves out of. Thank you for watching this obscenely long video, and I hope you've learned something today.
And with that, a special thank you goes to all my underwater train finders. Some Dude267, Orange Glass, Benjamin Owens, Panzerkitzun131-232, Josh Johnson, Metal4LifeGuy, Anzac A1, Arthur Roy, Tommy Rossini, LordCaptainVaughtThrust3rd, Joshua Long, Brian, JackCarsonsRiverVideos, Hayden DeGrow, MasterOfNone, LordHawk444, Alaric Jaspers, TheBaxter, ThatGuyWithABeard, Mark Holding, LockKraken, MurderDronesDoll, A- 8person723, DMTribeTifuno, HiroTrucker1, HendrikMotorsportsFan5, AlfonsoLapuche, Roa12860, Icerfur1405, Charles Kwiatkowski, DrRace78, and Matthew Wolf. Till next time, this is Darkness, and I bid you all a fond farewell.