This continues our piece yesterday covering the first 9 chapters of Bethany McLean and Peter Elkinds’ luminous book on EnronWhile we believe our take-aways from Chapters 10 – 22 of the book below are helpful reminders, there is simply no doing the book justice.  We would like to remind our readers that all current and new subscribers are welcome to a free copy of this or any book we have written up.[1]

The Enron Scandal’s Impact on Stakeholders

The Chapters below explain how Kenneth Lay and other top executives of the Enron corporation compromised their business ethics.  Those compromises would eventually obliterate the savings of many and create a crisis of confidence in American financial markets. After they filed for bankruptcy, the authors’ comprehensive work brought the Enron scandal to light with such detail we believe it may spur some healthy diligence that is often omitted in bull markets like today.

In our opinion, many investors and speculators have embraced firms despite financial statements that highlight severe problems with the underlying businesses.  At the same time, celebrity CEOs have mocked the Securities and Exchange Commission in front of the world stage.  As our White Papers and Quick Takes have documented, investors today are chasing returns as aggressively as they did at the peak of the dot.com mania.

With that in mind, we believe investing in companies with proven track records, helmed by solid management teams who employ honest accounting, has rarely been more important than today. 

Chapter 10: The Hotel Kenneth-Lay-a

Quote: ‘It started out as pure, clear, legitimate deals.  And each deal gets a little bit messier and messier.  We started out just taking one hit of cocaine, and the next thing you know, we’re importing the stuff from Columbia.’ Enron Executive –page 149

  • We learn about the background of Enron’s ambitious CFO, Andrew Fastow
  • Fastow’s background was in securitization – getting things off balance sheets – he was a darling of Jeff Skilling and became CFO at only 36 years old
  • Fastow and his team worked with a legion of auditors and consultants from Arthur Andersen and elsewhere to convert GAAP accounting rules into a playbook for corruption, deceit, and lying
  • James Hecker, an Anderson Auditor, described Enron’s accounting as “shambolic”

Chapter 11: Andy Fastow’s Secrets

Quote: All the structured-finance deals Fastow and his team cooked up were meant to accomplish a fairly simple set of goals: keep fresh debt off the books, camouflage existing debt, book earnings, or create operating cash flow. –page 155

  • The authors move us into the heart of Fastow’s darkness
  • Fastow and Skilling begin the descent into a byzantine set of transactions using Enron stock as collateral for structures that pushed or violated accounting rules at every turn while enriching themselves
  • With Glass-Steagall repealed in 1999, Fastow becomes an expert at exploiting the massive banking fees Enron generated to manipulate Wall Street’s lending and investment banking teams

Chapter 12: The Big Enchilada

Quote: Enron’s accounting games were never meant to last forever. … The goal was to maintain the impression that Enron was humming until Skilling’s next big idea kicked in and started raking in real profits. –page 171

Here we find the analogs to many of today’s market darlings so stunning we are going to break our takeaways into three distinct pieces: Regulations & The Past, Enron Energy Services (EES, the first “big enchilada”), and Enron Broadband (the second “big enchilada”)

Regulations & The Past:  Natural Gas & Wholesale Electricity

  • Up until this point in Enron’s life, the company has manipulated changing government incentives first in natural gas and then in electricity to create the illusion of being an industry leader
  • To the degree Enron ever had a true competitive advantage in anything it did in natural gas or electricity, that advantage was arguably fleeting
  • The company effectively created narratives that Wall Street loved and used whatever means necessary to meet various quarterly targets

Enron Energy Services (EES): The attempt to deliver electricity and gas direct to consumers

  • This is where the Enron story takes a remarkable turn as this concept had no basis in reality as regulators never indicated a desire to deregulate the utilities charged with supplying consumer markets
  • In the eyes of Enron’s senior executives, they knew better than the regulators
  • California was the one exception – they deregulated power delivery, and Enron spent a fortune losing money trying to roll out direct to consumer utility services – an endeavor that ended in disaster
  • Management responds to their total failure to deliver a “big enchilada” by completely changing up the deliverables, timetables, and targets to redirect investor attention
  • Faced with failure, the company goes on a hiring binge promising huge bonuses for salespeople who make deals with payments made on “Total Contract Values” – a number entirely of Enron’s invention and totally devoid from any economic reality
  • With such perverse incentives, the business is loaded with deals that lose vast amounts of money

Enron Broadband: The Klieg Light Syndrome Writ Large

  • With EES imploding in real-time and Jeff Skilling obsessing about Enron’s stock price, his decision to pivot into broadband, a “New Economy” darling makes sense
  • Despite knowing nothing about broadband or the internet, Skilling does the “com math” and realizes that investing $1bn into a dot.com related business would create $20bn in market-cap
  • And that is precisely what Jeff Skilling does: he plans a massive unveiling in January 2000 of an Enron Broadband division to help inflate his stock and redirects investors to the “new new thing”

Chapter 13: An Unnatural Act

Quote: There was so much at stake.  Enron’s shares were climbing again – they rose 55% in 1999 – and salaries and bonuses were soaring.  Every high-level Enron executive held options worth millions. -page 206

  • This is Enron’s descent into madness at the hands of Andrew Fastow and Jeff Skilling in our view
  • With so many SPEs and other shadowy deals dependent on the price of Enron stock and enormous amounts of stock-based compensation at the executive level, virtually all of Enron’s decision-makers have been compromised and engage in willful blindness at best and criminal negligence at worst
  • Fastow uses this situation as a means to set up a private equity fund that he controls while retaining his position as CFO of Enron
  • The private equity business he launches creates a staggering series of conflicts of interests between himself, Enron, Skilling, his direct reports, and the investment banks he works with
  • Fastow creates a financial merry-go-round of fraudulent transactions that, the more urgent and dire Enron’s economic position becomes, the more quickly his merry-go-round turns

This chapter must be read to be believed.  It is a testament to the quip, often attributed to the mafia, “that three people can keep a secret if two of them are dead.”  The book has all the details down to 30-minute calendar invites.  A testament to how “shareholder alignment” via aggressive use of stock-based incentive compensation can create massive cultural problems.

Chapter 14: The Beating Heart of Enron

Quote: ‘Like Microsoft created DOS, Enron is creating MOS: the market operating system.  And they can apply it everywhere.’ –Management Guru & Best-Selling Author, Gary Hamel, Explaining Enron’s Trading Operations -page226

  • Enron was the first to put energy trading online, effectively giving them a temporary monopoly on the critical information that drives energy trading movements
  • While Skilling told the street that Enron was a “logistics company” the truth is they were a massive casino that relied on wildly dangerous energy traders to make their numbers
  • By 1998, Enron gave their energy traders 5x the risk limits Morgan Stanley would give their own traders
  • The group promptly squandered billions trying to get into paper pulp trading, steel trading, and myriad other verticals where they had no expertise or advantage
  • The results would be a failure to implement at best or massive losses at worst

Chapter 15: Everybody Loves Enron

Quote: By May 1999, Enron had returned over 600 percent to its investors, one and a half times the return of the market’s most important index.  By early 2000, Enron’s return had hit 1,000 percent.  And by October 2000, Lay’s favorite slide showed that Enron had returned a stunning 1,400 percent since 1990, more than three times the gain of the S&P500. – page 229

  • If you want to understand today’s market, you must read this chapter
  • The authors explain how the soaring stock price became validation for every piece of optimism
  • Using conflicts of interest with bankers, Enron silenced any dissenters in the analyst community
  • As the stock rose, analysts and investors come to believe that the folks at Enron were infallible
  • This belief created a perception that Enron could become an industry leader at anything they did
  • Despite being readily available in public disclosures, investors turn a blind eye to the related party transactions, the conflicts of interest, and myriad off-balance sheet structures
  • With the cult of Enron in full swing, day traders on message boards attacked anyone who dared say anything negative about the company
  • We are given insight into Enron’s unveiling of the Broadband division, including an on-stage appearance by Sun Microsystem’s Scott McNealy, who attested to Enron purchasing 18,000 routers – the spectacle sent the stock price soaring 26% in a day
  • Analysts were not afraid to say that, at 60x earnings, over half the company’s value was attributable to business divisions that had not generated any actual earnings yet
  • Skilling and Lay do a remarkable job pivoting their logistics company into a “New Economy Stock” that suddenly goes from “energy” to “software” and, very quickly, the share price reflects this
  • Harvard Business School Professors swarm Enron’s campus to document and teach the firm’s brilliance, and The Economist authors a fawning piece about a speech given by Ken Lay –page 239-240
  • When asked what could go wrong at Enron, Skilling didn’t hesitate to reply: “I can’t worry about comets hitting the building” -page 245

KCR BELIEVES THE UNIFORM BULLISHNESS AROUND ENRON IN 2000 CAN BE SEEN IN COUNTLESS STORY STOCKS THAT DOMINATE THE NEWS TODAY.

Chapter 16: When Pigs Could Fly

Quote: As Enron’s stock was rising to new heights and the acclaim for Skilling and Lay was reaching new crescendos, where was the company’s former superstar, Rebecca Mark?

  • Rebecca Mark, who formerly ran Enron’s physical infrastructure division and lost a political battle with Skilling, had been spun out with a single Enron asset in July 1998
  • Rebecca Mark has her company, Azurix, enter into water infrastructure despite knowing precisely nothing about the water business, and the chapter details her descent into disaster
  • While she was technically separated from Enron, all her board members were from Enron (including Lay and Skilling), and the major difference was simply that she lacked access to the capital inflows conjured up by Fastow’s machinations
  • Overpaying for assets, poor management, operational failures, and an ill-fated IPO plays out quickly in the chapter which chronicles Rebecca Mark’s public demise
  • The ultimate irony is that her failure is used to heap yet more praise on Skilling as the Wall Street Journal and other reporters saw her demise as validation of Skilling’s “asset-light approach”
  • The grim reality, however, is that Skilling’s asset-light approach was in name only and while Marks’ business may have generated unacceptably low returns, her assets did, in fact, produce actual cash-flows unlike the furious deals Skilling and his minions cobbled together

Chapter 17: Gaming California

Quote: Deregulation of California’s energy market had gone into effect [in 1998] creating an enormous opportunity for energy traders …. In one appearance before the California Public Utilities Commission, Skilling claimed that the state would save $8.9 billion a year: ‘Let me tell you what you can buy every year,’ he said. ‘You can triple the number of police in Los Angeles, San Francisco, Oakland, and San Diego, and you could double the number of teachers.’ –pages 264, 265

  • This chapter focuses on Enron’s heavy reliance on exploiting government regulations to fabricate success through a series of nefarious schemes that loot the public
  • The firm believes it truly is smarter than anyone and demonstrates an unfortunate willingness to browbeat the very public officials who created the opportunities they exploited to maximum effect
  • To shorten a chapter filled with the grimy details of Enron’s rank hypocrisy, deregulation became a game that Enron’s traders sought to exploit through a collection of treacherous schemes with names like Fat Boy, Ricochet, Death Star, Get Shorty, and Megawatt Laundering
  • In almost every instance, the company’s traders intentionally diverted supply or overloaded transmission capacity to force Californians to pay absurd rates
  • The book notes that in June 2000, California’s wholesale power prices soared to $3.6bn, or roughly half of what the electricity costs were for the entire year of 1999.
  • Enron’s gains required a willingness to send the state into a period of severe crisis, with rolling blackouts becoming the norm
  • The number of documented crises exploded from 17 in 1998 to 55 in 2000 and 70 in 2001
  • Having printed fortunes from this horrendous activity, Enron worked furiously to bury the behavior of their traders while Ken Lay, Jeff Skilling, and others began mocking the stupidity of California’s regulators for failing to “deregulate properly”
  • Having insulted the regulators and politicians in public across many venues, one is hardly surprised to see that Enron came under regulatory scrutiny as California’s public went into a rage

Chapter 18: Bandwidth Hog

Quote: That memorable analysts meeting in January 2000 – the one where Skilling unveiled Enron Broadband, projected that its trading business would be generating more than a billion dollars in operating profits by 2004, and insisted that it already deserved and extra $37 in the price of every Enron share – presented a troubling problem for the executives who worked in the new division.  Though Enron’s stock started to jump within minutes, that was only because the analysts didn’t know what the broadband insiders understood all too well: they didn’t really have any business. –page 284 bold emphasis ours

  • This chapter explains the nefarious effects when senior management makes impossible promises
  • In bull market manias, it is common for people who make bold claims about changing industries by bringing new features to life to be heralded as genius
  • The downside is that when the product is delivered, if it is delivered at all, it is often far later than desired, rife with fabrication and, by the necessity of the innovative process itself, accompanied by much lower economic returns than originally envisioned
  • Enron never had a broadband business, and this chapter explains preposterous deals with Blockbuster and telecom providers for Netflix-like services that simply did not exist
  • Worse, these deals then went through a mangled version of mark-to-market accounting where the future expected gains were booked as profits despite lacking any credible path forward
  • We learn about committed accountants uncovering huge losses only to be shunted aside while senior business executives begin dumping large amounts of stock as the firm continues to maintain the veneer of everything being perfectly fine within the company
  • The chapter also delves deeply into the machinations of Fastow and his creation of the “Raptors” – a collection of accounting contrivances that helped Enron hide losses in impossibly complex (and stupid) structures that effectively had Enron hedging business risk with itself
  • We believe the technical detail of this chapter is a must-read for any young investor

Chapter 19: “Ask Why, Asshole”

Quote: BusinessWeek celebrated [Skilling’s] new position [as CEO on December 13, 2000] with a worshipful cover story … Worth magazine described him as “hypersmart” and “hyper-confident” – and named him America’s second-best CEO … [but] The bull market was over.  Where investors had once cheered the market’s every move, now they grew angry as their savings dwindled and they realized they had gotten caught up in a classic bubble.  As stocks sank, the game changed. … In the bull market, investors always saw the glass as half full; now, for the first time in years, they were seeing it as half empty. –page 313 & 318

  • The chapter documents how Jeff Skilling began to look to the stock price as proof of excellence rather than any real economic profit within the firm
  • The end (the stock price) effectively became the means with one employee stating Skilling had become “…more of stock promoter than a businessman”
  • The chapter documents that Skilling professed in private he was miserable as he struggled to maintain Enron’s rosy narrative amid crumbling economic performance
  • We are introduced to the short-sellers Jim Chanos of Kynikos and Richard Grubman of Highfields Capital, who begin asking challenging questions about Enron
  • Skilling, not accustomed to being asked anything but fawning soft-ball questions, calls Richard Grubman an “asshole” on an earnings call when he asks for Enron’s balance sheet
  • The chapter makes it clear that short-sellers’ willingness to do deep-dive diligence, particularly on companies that have experienced outsized returns trading at high multiples, is actually a market check on exactly the type of behavior going on at Enron
  • The chapter also moves into the rapidly deteriorating health of the “Raptors” that Fastow had used to hide losses and manufacture profits for Skilling
  • The chapter ends with Skilling speaking in the power-starved state of California and having a member of the audience throw a pie in his face
  • And the finger-pointing begins – with Skilling denying ever seeing reports from lawyers working with Fastow and Fastow insisting Skilling was on-board with everything and the Board denying they were aware of the accounting fraud associated with Fastow’s private entities

PAUSE:  Before progressing to the final three chapters, the KCR research team would ask that our readers pause.  Contemplate the following.  Jim Chanos, a man who has built a remarkable track-record shorting stocks, who helped out Enron’s fraud, has coined today’s markets the “Golden Age of Fraud.”   Do you believe Chanos became “suddenly stupid”?  WE THINK NOT.

Chapter 20: I Want to Resign

Quote: As for Skilling’s mood, it seemed to oscillate between depression, righteous indignation, and manic excitement about the next big enchilada. –page 350

  • Skilling begins to contemplate resigning as he takes the falling stock price personally
  • Ken Lay also used a series of deft maneuvers to sell stock in Enron to make good on loans secured by the stock without disclosing it to investors or the public
  • Here we find some ambiguity in the authors’ ability to provide detail: the actual reasons behind Skilling leaving cannot be ascertained with certainty, but what can be understood is that the difficulty of actually trying to run the underlying capital assets was brutally difficult for Skilling, a “Great Man” who loved proclaiming big ideas without the necessary acumen to implement them
  • Skilling resigns – considering the compensation he left on the table, the market’s fears are awakened
  • Ken Lay, who has a limited understanding of Enron’s businesses, is suddenly back in the CEO chair

Our summary take-away from this chapter can be summarized by Warren Buffett’s legendary quip: “When a manager with a reputation for brilliance tackles a business with a reputation for bad economics, the reputation of the business remains intact.”

Chapter 21: The $45 Million Question

Quote:   

Dear Mr. Lay,

Has Enron become a risky place to work? For those of us who didn’t get rich over the last few years, can we afford to stay? Skilling’s abrupt departure will raise suspicions of accounting improprieties and valuation issues.  I am incredibly nervous that we will implode in a wave of accounting scandals.  … we booked the Condor and Raptor deals in 1999 and 2000, we enjoyed a wonderfully high stock price, many executives sold stock, we then try and reverse or fix the deals in 2001 and it’s a bit like robbing the bank in one year and trying to pay it back 2 years later.

Part of a letter to Ken Lay from former Arthur Anderson employee hired by Enron, Sharon “The Buzzsaw” Watkins –pages 355 & 356

  • The details are profuse and profound in their implication and meaning
  • To simplify the spectacular research and reporting done by the authors: the bomb goes off
  • The crazed financial machinations of Fastow and Skilling fall into public view, and the world learns that Fastow made over $45 million running partnerships where he represented both Enron and the partnerships he built to hide over a billion in losses for Enron
  • Ken Lay’s attempt to rally the media and Enron’s employees fail – one employee asks him in a public forum if he “is on crack” and advises that if he is not, this would be a good time to start
  • Fastow is put on leave shortly after Lay insists in public that he and the board are aware of his dealings

Chapter 22: We Have No Cash (the Enron and Arthur Andersen Scandal Laid Bare)

Quote:   

The machine at [Arthur] Andersen’s Enron office was quickly overwhelmed; dozens of trunks and boxes filled with documents – more than a ton of paper – were shipped to the main downtown office, where files awaiting destruction spilled out into the hallways outside the shredding room.  It was more than the entire Houston office typically shredded in an entire year.  The load was so great that Andersen summoned a shredding truck from a local disposal company called Shred-It.  (The company’s motto: “Your secrets are safe with us.”  Andersen’s offices in London, Portland, and Chicago joined in, shredding their Enron documents.  In addition to the paper, almost 30,000 e-mail messages and computer files were deleted. –page 383

  • The collapse of the storied Arthur Andersen, compromised by Enron, begins in full
  • The chapter documents the rapid demise of Enron once the truth creeps into the daylight
  • Where there is a large amount of debt or cash obligations that are effectively ignored at the peak of bull-markets due to inflated equity valuations, trouble is always an unexpected step away
  • Enron went from the most powerful force in energy trading to suddenly at the mercy of its banks, then its once-smaller rival, Dynegy, and then into the largest bankruptcy in history
  • The lesson here is inflated equity valuations + permissive lending environments + accounting games = disaster

Epilogue: Isn’t Anybody Sorry?

Quote:   

It was an astonishing comment on the mores of American life at the dawn of a new century.  In the aftermath of one of the largest corporate scandals in American history, precious few were willing to admit that they had done anything wrong.  Wasn’t anybody sorry? 

The larger message was that the wealth and power enjoyed by those at the top of the heap in corporate America … demand no sense of broader responsibility.  To accept these arguments is to embrace the notion that ethical behavior requires nothing more than avoiding the explicitly illegal, that refusing to see the bad things happening in front of you make you innocent, and that telling the truth is the same thing as making sure that no one can prove you lied.   –page 407

The KCR team cannot think of a more potent and powerful comment on the state of Enron and the dot.com mania than the one above.  The lessons from the dot.com era resonate with the peaks of speculative bubbles over many centuries.  As always, the KCR research team encourages individual investors to seek personalized financial advice.  Never have we seen a more precarious set of markets than we do today.

Although we doubt they will ever see this, the KCR team would like to thank Bethany McLean and Peter Elkind for their astonishing work.  The piece is as invaluable today as it was at the time of publishing almost twenty years ago.  We hope that readers of our takeaways will go out and buy the book in droves and encourage subscribers who do not own it to take us up on our offer for a free copy.

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