Are you one of the smartest guys in the room? – Part 1

The once-dominant American energy, commodities, and services corporation Enron Corporation is now associated with deceit, corruption, and devastating debts. The scandalous corporate tale of our time is certainly the downfall of Enron, whose rising earnings were followed by the biggest bankruptcy case in US history. But how does a reputable business rise to the pinnacle of its industry only to collapse into economic tragedy?

In their book The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron, authors Bethany McLean and Peter Elkind delve into the company’s past to discover the fascinating individuals who were responsible for the scandal and discover how greed and deceit can result in such a dramatic fall.

Do you ever get the feeling that the past is repeating itself? When the American energy behemoth Enron declared bankruptcy in 2001, it undoubtedly seemed that way. The company’s failure as a result of massive indebtedness and dishonest business methods was a recurrence of issues they had faced from the company’s beginning.

Enron was in reality already in debt in 1987, only two years after its founding. In 1985, Houston Natural Gas (or HNG) and InterNorth, two pipeline firms, merged to establish Enron. The business was renamed Enron in 1986 after Ken Lay, an educated and aspirational man, became the CEO.

Unfortunately for Lay, it didn’t take long for Enron to experience severe financial difficulties. Enron claimed a $14 million first-year deficit at the beginning of 1986, and by January 1987 its credit rating had fallen to junk status. What took place?

Enron had been using unethical business tactics that had put the company in danger of going out of business, and a particular division called Enron Oil was the biggest problem. Enron Oil was essentially betting on oil prices; in addition, the oil traders were manipulating their revenues. Enron Oil was neither producing nor selling oil.

For instance, they would arrange transactions with fictitious businesses that permitted them to incur a big loss on one contract, only to make up for this loss with revenues from a subsequent contract. They were able to transfer profits from one quarter to the next thanks to their false losses.

Enron sought to convince Wall Street that it could generate a profit that would rise gradually over time, a pattern that the stock market is eager to reward. But by 1987, Enron’s oil trading business had lost so much money on risky bets that the entire business was in danger of going down.

But Ken Lay was ready to take action. He reassured Wall Street experts that this decline was just an anomaly that would never happen again. But as we now know, Enron’s corporate culture was fundamentally based on dishonesty and irresponsibility.

Enron was able to overcome its initial crisis, but by the end of 1988 it was in trouble once more. The company’s primary difficulty, which Enron planned to address by recruiting Jeffrey Skilling, was that it lacked a business model that could generate meaningful profitability.

Skilling, a Harvard Business School graduate who had previously worked as a consultant for McKinsey, joined Enron in 1990 and was appointed CEO of a brand-new business called Enron Finance. Skilling, a very intelligent man, played a significant role in Enron’s temporary metamorphosis into a thriving business.

First, Skilling transformed Enron into a “Gas Bank,” as he put it. The plan was for gas producers to enter into a contract with Enron under which they would sell their commodity, and Enron would then enter into agreements with clients. The difference between what Enron paid the producers and what it charged its consumers was its profit. But Skilling also identified a method to profit from these arrangements by exchanging the actual contracts.

The second phase of Skilling’s grand scheme was persuading Enron to adopt mark-to-market accounting. Mark-to-market accounting records the complete estimated value of the entire contract on the day it is signed, as opposed to conventional accounting, which records revenues and profits from a contract as they are received. Therefore, firms that employ mark-to-market accounting give the impression that they are expanding swiftly by promptly recording all prospective earnings. Consequently, Wall Street speculators are pleased, and the stock rises.

Last but not least, Skilling created a company culture where pure intelligence predominated over experienced management and practical knowledge. In fact, he once said that he liked to recruit “people with spikes,” which meant that if an executive had a single skill, or a spike, Skilling would hire him despite any faults.

That led to the creation of a firm full of egomaniacs, social misfits, and backstabbers, but Skilling didn’t care as long as they deftly carried out his instructions. But is it conceivable for a business to have success driven only by a talented workforce? Not in the Enron case.

Enron was revolutionized by Jeff Skilling, but most individuals outside of the organization were unaware of him until the mid-1990s. Rebecca Mark, a female celebrity in a male-dominated field, served as the public face of Enron.

Even though they had enormous populations and similar energy needs, emerging nations were frequently disregarded by Western firms until the 1990s. As the CEO of a branch of the corporation named Enron Development, Rebecca Mark’s job was to sign energy agreements with as many developing countries as possible in order to promote Enron’s brand globally.

So she started traveling the world, and by the middle of the 1990s, Enron Development seemed to be a smashing success, with Mark taking credit for it. While she was content to play up her attractiveness and sparkling grin, Mark’s defining quality was her optimism, a firm conviction that things will turn out for the best.

The deal-making atmosphere at Enron Development was gradually polluted by Mark, despite her assurances and smiles; as a result of Enron’s problematic compensation plan, her colleagues were led to believe that their only responsibility was to close as many agreements as possible.

Developers, for example, received bonuses on a project-by-project basis, which meant they received payment after a transaction was finalized – before a single pipe was installed or a foundation was poured. There was no one else at Enron to assume ownership of initiatives once they were off the ground, so developers had no motivation to carry out the agreements they had signed.

As a result, while Mark believed nothing horrible could happen, tragedies happened every day. For instance, in 1995 Enron invested $95 million in a power facility in the Dominican Republic. But as it turned out, the government of the Dominican Republic refused to pay for the electricity the facility produced. Thus, by the middle of 2000, Enron’s substantial investment had only generated a meager $3.5 million!

Enron announced in 1996 that Jeff Skilling will take over as the organization’s new president and COO. Skilling, who had just been promoted to the company’s top position, immediately started rebuilding Enron to fit his image. Trading took over as Enron’s primary priority, but Skilling also downplayed legacy initiatives like pipeline construction and natural gas extraction.

Skilling intended to advance despite the fact that Enron had already established itself as the leading name in the natural gas sector. Even though Enron was still an outsider in the electricity industry, he wanted to do even more trading and extend his business beyond gas.

Skilling used every opportunity to get rid of the company’s outdated, profitable business practices while reshaping it. As a result, by the end of the 1990s, Enron had undergone a significant transformation: trading and contracting were now its primary activities.

However, Skilling’s adjustments had other effects, one of which was that Enron turned into a company where taking risks and lying about money was practically expected. Why? Because Skilling used a completely absurd method to determine Enron’s annual earning targets: he would choose a fictitious figure that only represented what Wall Street wanted.

The issue was that a business built around trading and making agreements couldn’t realistically expect its profits to grow consistently because trading desks can make or lose millions of dollars in a single transaction. Since Enron’s Risk Assessment and Control department, or RAC, would step aside as long as a deal received the required commercial support, the risks associated with the agreements it mediated increased with time. At the same time, Enron was able to position itself as a business that managed risk better than any rivals because to the RAC’s very existence.

Enron had to use some cunning tactics, however, in order to meet the earnings projections it had promised investors. The business exaggerated its projected revenue in order to postpone disclosing the losses it was actually incurring. Skilling changed the way Enron did business, but Andrew Fastow changed the way it handled its finances.

Fastow, who had worked for Enron’s financial division since 1990, was given the title of chief financial officer (CFO) in 1998, and that was when everything started to go wrong. He and his team got to work managing Enron’s finances to bridge the gap between the company’s actual operations and the public image Skilling and Lay desired.

How? by establishing financial systems that concealed Enron’s debt. Use Whitewing as an illustration. This Enron subsidiary was established in 1997 with the goal of buying and disposing of the company’s underperforming assets. If Enron built a power plant for $8 million with the expectation that it would be worth $10 million, it would record a $2 million profit in its books.

Enron should have eliminated the $2 million profit it had made and replaced it with a $1 million loss when the plant underperformed and only generated a market value of $7 million. But instead, Enron would just pay Whitewing the full $10 million for the plant. Then Whitewing would sell it for $7 million and receive the $3 million in Enron stock as payment.

Enron effectively disguised a $1 million loss as a $2 million profit because the $3 million in stock it issued would not appear as a loss on the books. Fastow was producing money for Enron, but he also knew how to take care of himself. For instance, he established the LJM fund in 1999, which stands for Lea, Jeffrey, and Matthew, the initials of his wife and two sons. Similar to Whitewing, LJM bought underperforming Enron stocks, allowing the business to keep them off its balance sheets.

Fastow, who was CFO at Enron and headed LJM, had a clear conflict of interest because he effectively had the power to bargain with himself. In the end, Fastow’s dual roles enabled him to secretly generate a personal profit of tens of millions of dollars.

Check out my related post: What can we learn about culture from the Enron?

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