Enron is a household name, but not the way that Walmart, Facebook, or Amazon are household names. No, the name Enron is synonymous with corporate fraud and corruption.
The Enron story is one that’s riddled with false promises, skewed financial data, and downright lies from management to investors that led to thousands of people losing their retirement funds. The collapse of Enron in late 2001 was one of the most painful losses ever seen in the stock market.
An estimated $74 billion was lost during the Enron scandal, according to CNN. How did Enron get away with its misdeeds for so long, and how can investors avoid falling for another fraud like it? Let’s take a look.
The History of the Enron Scandal
Enron Corporation was the result of a merger between two relatively small energy, commodities, and services companies, Houston Natural Gas and InterNorth, in 1985.
Following the merger, Enron grew relatively quickly — or at least it told its investors it was growing quickly. In 2000, Enron claimed to generate revenues of around $101 billion. Of this revenue, the company reported that nearly $2.5 billion was net earnings.
By this time, Enron was an important player in the electricity, natural gas, communications, and pulp and paper industries. As the company grew, it received several accolades, perhaps the most impressive of which was being named “America’s Most Innovative Company” for six consecutive years by Fortune.
However, the financial reports Enron was producing were the result of systemic accounting fraud.
Of course, the investing community had no idea. When the fraudulent reporting came to light in late 2001, institutional investors were the first to hear about it, leading to the sale of massive blocks of shares. By the time retail investors realized what was going on, many of them had lost colossal portions of their initial investments. Some even lost it all.
Retirement accounts, college funds, and public financial safety nets that held investments in the company were flushed down the toilet in no time. The devastation is still being felt by thousands of people today, many of whom are unable to retire as a result of the losses they experienced.
Those at the helm at Enron when the scandal came to light not only ruined the lives of their investors, but they also ruined their own lives. Many faced charges and were sentenced to lengthy prison terms and fines. Cliff Baxter, the former vice president of Enron, left a suicide note and took his own life.
Although Enron reported financial data in 2000 that would excite any investor, the company was falsely reporting positive cash flow when it was actually hemorrhaging money. The actual numbers in 2000 were nowhere near the reported figures.
Take a look at the chart below to get an idea of how blatantly misleading the data was:
|Fiscal Year 2000||Reported||Actual|
|Cash From Operations||$3,010,000,000||$-1,539,000,000|
|Pretax Interest Coverage||2.54||1.11|
|Cash Flow/Total Obligations||29%||-0.70%|
(Data courtesy of Forbes.)
While Enron company reported solid cash from operations, it was actually losing hundreds of millions of dollars. At the same time, Enron only told investors about half of the $22 billion in debt it carried, grossly exaggerated its earnings, and made it look as though interest expenses were hundreds of millions of dollars lower than they actually were.
The most telling data in the chart comes from the ratios in the last two rows. While the company was reporting positive cash flow, it wasn’t bringing in nearly enough money to cover its debts. Those debts, reported at less than 50% of the company’s total capital, actually represented nearly 70% of the company’s total capital.
Essentially, Enron was drowning in debt. However, it got away with it for years because the false reporting led to heavy interest from the investing community, giving the company plenty of investor dollars to work with.
How Enron Got Away With It for So Long
One of the biggest questions asked after the Enron scandal was, “How could this happen?” It’s a valid question. With all of the regulatory authorities that cover the stock market, how did Enron get away with stealing so much money from investors?
Enron’s strategy was a mix of contributions to regulators, bullying tactics that pushed other companies out of the United States, and the use of illegitimate private companies to hide debt and simulate profits.
When it came to regulators, Enron used massive donations to make friends in high places. In fact, it donated almost $2 million to the Bush-Cheney campaign, making it one of the largest donors to the sitting presidential administration. As such, if Enron needed something from a regulatory standpoint, getting access to lawmakers was simple.
At the same time, the company was known for bullying other companies to give into its demands. With its stronghold on administrators and regulators, many companies that didn’t agree to comply with Enron’s demands left the U.S. to do business in countries like Venezuela. As competitors abandoned ship, they left fewer choices for investors to pick from.
Enron made many deals by negotiating with bully-like tactics. Some of its most questionable included:
Enron was notorious for prepay transactions. In these transactions, the company made deals with big banks — including Citigroup and J.P. Morgan Chase — that it was able to hide from investors.
Essentially, the big banks paid Enron in advance for commodities like natural gas. This protected both the banks and Enron from future changes in the price of commodities. Upon the maturity of the agreement with lenders, Enron would have to deliver the commodities equal to the value of the deal plus interest.
These prepay transactions were nothing more than a clever way to disguise debt. As a result, from December 1997 through September 2001, the company borrowed around $5 billion through these prepay transactions. However, due to the creative and manipulative structure of these transactions, it only reported about $148.2 million of this debt on its balance sheet.
In late 1999, Enron launched an elaborate scheme to artificially inflate its apparent cash flow from operations. The project started with Enron building an outside partnership with Nahanni that borrowed $485 million from Citibank and took another $15 million in equity capital.
With these funds, the Nahanni partnership purchased $500 million in Treasury securities and gave them to an Enron subsidiary in exchange for a 50% stake. Enron then turned around and sold the bonds, reporting the revenue from the sale as cash from operations.
The problem was that this wasn’t cash from operations — it was a loan. Two weeks after the books were closed, Enron repaid the loan from Citibank. As a result, Enron was able to artificially inflate its cash flow from operations by $500 million, reporting $1.2 billion in operating cash flow for the year.
Enron also took part in various mark-to-market transactions. This is the process of projecting earnings from a project, discounting the earnings back to present-day figures, and reporting the imaginary total as income.
One of the most famous of these mark-to-market transactions was part of a deal to provide energy services to American pharmaceutical giant Eli Lilly. In February 2001, Enron ran a computer simulation of energy savings it could provide to Eli Lilly. Enron then calculated its share of this imaginary savings, discounted it by 8.5%, and included this figure in its income statement.
This elaborate mark-to-market scheme meant that Enron reported $40 million in quarterly profits at a time when it was actually experiencing extreme losses.
Future Tax Savings
When Enron collapsed, investors learned of future tax savings that were being reported as immediate savings. To do this, the company used a series of convoluted transactions involving its headquarters, Canadian subsidiaries, corporate jets, and other assets.
These assets were included in various deals — primarily with Bankers Trust and Deutsche Bank — that would decrease Enron’s tax burdens over time. However, during the quarter when the deals closed, Enron reported the tax savings as immediate. This resulted in the company reporting $886.5 million in tax savings between the years 1995 and 2001 that hadn’t actually happened.
Pretend Asset Sales
Finally, Enron entered into deals with various private names that were designed to allow the company to borrow money against illiquid assets.
When these funds were borrowed, the company reported the borrowed money as revenue from asset sales. This led to Enron inflating its income by around $1.5 million while underreporting its debt by around $828 million.
The End Result
All of these shady transactions gave the company the ability to hide its financial struggles, telling investors it was doing better and better quarter after quarter until there was no way to hide their deception anymore.
Ultimately, these transactions snowballed out of control and the company collapsed. The scandal came to light in October 2001, and Enron filed for bankruptcy in December 2001.
How to Avoid Getting Involved in the Next Scandal
The Enron scandal was an elaborate one that was nearly impossible to spot if you weren’t specifically looking for it. Enron was so big it seemed impossible for it to overstate earnings or understate debt. The company was doing so well and was so trusted by regulators, institutional investors, and suits-and-ties of all sorts. So, why wouldn’t people invest?
This general trust for the company led investors to make moves without doing their research. Ultimately, if you want to avoid being a victim of the next big scandal, the key is doing your research.
Looking back at the Enron scandal, there were several transactions that should have raised red flags.
For example, when the company was borrowing money against assets and reporting the funds as money from sold assets, investors could have researched those assets and saw that they were still owned by Enron or one of its subsidiaries — they were never really sold.
When researching an investment, it’s wise to dig into the company’s transactions that are leading to revenue. For example, mark-to-market transactions are pretty easy to sniff out, as they’re based on perceived future revenues.
While investing is all about hoping to build money through future gains, you never want to invest in a company that reports future revenues in the now.
Perhaps the most telling clue as to what was going on at Enron was the shrinking percentage of “revenue” that became earnings toward the end of the company’s fraudulent run.
In the fourth quarter of 1998 through the first quarter of 2000, earnings as a percentage of revenue came in at about 2%. Starting in the second quarter of the year 2000, earnings as a percentage of revenue fell to less than 0.5%. This dramatic drop was a major red flag that should have screamed “sell your shares” to anyone looking for it.
Finally, when investing, even if a stock is generating incredible returns, continuously research and ask yourself, “Does this make sense?”
For example, from early 1999 to the end of 2000, oil prices were rising, so a rise in the value of an energy company like Enron would make sense. However, at the beginning of 2001, oil started to see dramatic declines.
Even though the energy sector was feeling extreme pain, Enron — one of the world’s largest energy companies — was still reporting growing revenue. Investors who dug into Enron’s financial reports would have seen this as simply nonsensical.
The Enron scandal was painful for everyone involved. While institutional investors didn’t take quite as big of a hit as retail investors did, everyone involved lost money. Not only did the scandal lead to an extreme loss of money, but it also led to the suicide of one of the company’s executives and prison sentences for several others.
Following the Enron scandal, several new regulations have been instituted to protect investors from scandals like this taking place in the future. Nonetheless, fraud and scams still happen in the stock market and probably always will.
While regulatory agencies like the SEC and FINRA do everything they can to protect investors, they cannot — and will not — catch everything. As an investor, the best way to protect yourself is through adequate research. When making investment decisions, take your time and do your research.
Most importantly, when looking into the company’s financial data, ask yourself, “Does this make sense?”