The Enron scandal was the emblematic corporate scandal of early 21st century American capitalism. Wall Street and retail investors fell in love with what had been a small Houston-based pipeline and utility company – one that had grown its sales from $10bn to the totemic $100bn mark within just a few years through the simple trading of energy options and futures. The only problem was that the company’s huge revenues and profits existed mainly on paper and then only, as subsequently became clear, because its executives were cooking the books. A book, a film and a stage play later, and Enron remains firmly tied in the public imagination with everything that went wrong with the 1990s stock market boom.
The consequences of Enron’s collapse into scandal were immediate and long-lasting. Many investors lost fortunes, thousands of former employees their pensions and life savings, venerable accountancy firm Arthur Anderson, which audited Enron’s books, imploded in disgrace, while several people spent long terms in prison – former chief executive Jeffrey Skilling was only released on parole in 2019. Former chairman Ken Lay died before seeing the inside of a prison cell, while former chief financial officer Andrew Fastow, who used illegal means to hide Enron’s losses, served time but now works as a motivational speaker.
However, there were people who went against received Wall Street opinion and correctly diagnosed a problem with Enron’s accounts and either shorted the shares or bravely blew the whistle at great personal cost.
Jim Chanos has a well-deserved reputation for picking a short position. His hedge fund, Kynikos Associates, founded in 1985, hit the headlines recently after correctly shorting Wirecard’s shares before the German payments company eventually collapsed into scandal.
As far as Enron was concerned, it all started when Chanos got a call from a friend working at a Texas hedge fund to talk about a strange form of accounting that had just been reported.
“It was a piece in the regional edition of the Wall Street Journal talking about how the energy merchant banks had gotten approval from the SEC to use an aggressive form of accounting for their long-term derivative trades. That is, they were allowed to book the estimated future profits immediately on a discounted basis,” he told Investors’ Chronicle.
Chanos had come across this type of accounting in the early 1980s when there had been a series of annuities scandals at life insurance companies which had been aggressively forward-loading the profits. “So I knew that in the hands of dishonest management, the assumptions would get too aggressive, and that they would probably be front-loading more profitability than would be the actual case over the life of the contract," he said. "And so that's when we started looking at Enron, specifically. And I think that was September 2000.”
A closer look at Enron’s books confirmed for Chanos that something was wrong with how the company was reporting its profits. “First, there was not only heavy insider selling of the stock, but there were a number of senior executive departures…when you see an insider selling stock and leaving, that's generally something to pay attention to. The second thing I noticed was just how low Enron’s return on capital was.”
Enron basically was simply not earning enough money to keep itself solvent. “It was earning, if you accounted for the derivative book, as well as the debt equity, somewhere around 6 per cent on its capital, which is really, really low," Chanos said. "We sort of looked at Enron as an energy hedge fund, right? It was a mix of different energy businesses driven by trading. And so, if you thought about it, Enron was trading at six or seven times book at that time but was only earning 6 per cent on the capital. And in the late 1990s, 6 per cent was basically where the 10-year treasuries were trading. They weren't earning their cost of capital. And that was despite being highly leveraged. Any company that is growing rapidly, but earning below the cost of capital is in effect liquidating.”
Chanos also noticed the strange official disclosures that Enron executives were acting as partners in entities that did business with Enron: “These were the [Andrew] Fastow Partnerships.”
Enron had created counterparties to trade with itself and guarantee any future losses by issuing Enron shares – in other words, hiding off-balance-sheet debt. “So we had seen enough by these three points that we initiated a position in late 2000. Of course, it moved against us at first, as these things tend to, but by the time Jeffrey Skilling left in August 2001, we had a full 5 per cent short in place.”
Sherron Watkins joined Enron in 1993 after a career as an auditor and corporate accountant at Arthur Anderson and MG Trade Finance, before leaving for Houston and Enron in 1993. Her brave attempt at raising the alarm made her a Time person of the year and helped bring in far greater protection for corporate whistleblowers in the US. She now teaches corporate ethics at Texas State University.
Watkins began at Enron by managing a portfolio jointly with the California public employees’ pension fund (Calpers) and her initial impressions of the company were favourable. “I found Enron to be a very large company, but also very entrepreneurial,” she told Investors’ Chronicle. “Jeff Skilling had started the gas bank, and Enron was really the first company to build up this amazing trading capability. And I thought that was a good add-on to the regulated, gas pipeline business… So all-in-all it was impressive in being big, but also nimble.”
However, she did notice a certain instability. “At Enron it was a double-edged sword. We were always reorganising. If you were stuck under an uninspiring boss, you didn't have to stay there long, within six months things would just get reorganised… So the cream rises to the top – people that are hard-working, ambitious with great ideas start to implement them. But the flipside of that is a bit of chaos. You can have some people start doing the wrong things and you don't have the structures in place to stop it.”
Where it started to go wrong, in Watkins’ judgement, was in 1996: “In the third quarter, there was no volatility in the gas market, and as a result it looked like we would miss our earnings targets.”
So, in the spirit of doing something, Enron started using fair value accounting to mark assets up.
“Hardy Oil & Gas, UK, was selling [its] US arm, so Enron financed a management-led buyout, invested $95m and called it Mariner," Watkins said. "Then Enron purchased all of Clinton gas systems with another management buyout… At the end of September, Clinton Gas was a $50m deal, they wrote it up to $75m. And Mariner was a $95m deal that they wrote up to $150m.”
Watkins tackled the chief financial officer about writing up hard assets when the basic principle of fair value accounting is that you use it to write things down and was told in no uncertain terms to leave it alone: “I got in trouble. Andy Fastow chewed me out: ‘Look, you're in my finance department, you're not in the accounting department.’ And it made me very uncomfortable.”
When Watkins finally discovered the accounting fraud in 2001 her attempt to warn chairman Ken Lay was a key moment in the drama. “My impression of Ken Lay was that he behaved like an absent landlord who was someone who was very willing to look the other way as long as the numbers were being met… It is a little bit like the Titanic. I'm the crew person. I see the water pouring in, I run to go warn the captain and your expectation is to hear the alarm bells and see the lifeboats – business lines being saved; cash being shored up. Instead, it was almost like Ken Lay turned to the people around him and said: ‘Hey, we're supposed to be unsinkable. Look back at the plans, icebergs shouldn't matter to us!’”
Howard Schilit has been a Wall Street fixture for decades and founded a successful independent research house that provided in-depth forensic accounting research to subscribing clients. His testimony at the Senate Enron hearings put the sell-side analyst business under a severe spotlight, by simply presenting several pages of questionable Enron statements from publicly available sources. His book, Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports, is now in its fourth edition.
“In 2000, I think Wall Street was looking for the next star. And Enron was beginning to become an enormously important client of the investment banking firms and they began touting that company,” he said.
“It was starting to grow pretty dramatically… If you look at [its] last audited financial statements, their revenue hit $100bn; there were only seven or eight companies in the US that had sales of that size.”
What piqued Schilit’s interest was that Enron added hugely to sales at an appalling time in the markets. “The markets were terrible and Enron's revenue had increased from $40bn to $100bn in one year – without any transformative acquisitions! Okay, so it was a rocketship.”
But it was the level of sales that gave the fraud away: “Enron was hiding debt in off-balance-sheet partnerships, which is 100 per cent true, but it wasn’t the main fraud. What got Wall Street and investors excited was the 150 per cent growth in sales.”
But no one seems to have questioned how improbable this growth was. “It takes an average of 27 years for a company to grow from $10bn to $100bn," Schilit said. "It is a very, very big jump. So Enron reaching that in just five years is unprecedented. So that's automatically a red flag.”
Basically, in its simplest terms, Enron, acting as a trading business, was booking its fee for a trading transaction as gross profit and not simply as revenue from which costs are deducted. “If Goldman Sachs, which is primarily a trading house, would gross up the value of all [its] trades, then [its] revenues would be in the trillions of dollars,” Schilit said.
While the mega accounting frauds might be slightly harder to pull off, Schilit, like Jim Chanos, sees a different danger for today’s investors, particularly in the use of self-adjusted metrics and internal performance targets. “Investors are still being tricked in different ways. The reason I continue to write and teach about all of these new tricks is because the techniques management uses to mislead never ends.”