Enron – a case of moral bankruptcy

Enron Logo - “The Crooked E”I’m currently reading a couple of books about Enron and fascinating they are too, if you like that sort of thing, which I do.

What happened with Enron then?

Very briefly: they borrowed from the future to make themselves look profitable in the present, but no-one can do that indefinitely. Astonishingly, for most of the time they were within the letter of the law. Remember, a company’s Annual Accounts are supposed to be an account or an explanation presented to the owners which explains what their officers and employees have been up to during the previous 12 months. However, by the late 1990s there were many different ways of accounting for any given set of facts.

Of course, after a while the actions they took were definitely outside the law. In some cases corporate officers defrauded Enron itself in a complex game of financial cups and peas, in others they defrauded Enron’s owners by lying to Wall Street, and a huge number of senior executives quietly jumped ship during Enron’s last year of trading cashing in tens or hundreds of millions of dollars worth of Enron stock in the process, walking and quacking like insider traders as they pocketed the cash and “retired”.

Reading the various books on the subject, it’s clear that most of those involved either had no sense of right or wrong or let it erode over time. The question always seems to have been “is it legal?” not “is it right?”. These were people who had ferocious intellects but who had no moral sense and no internal breaking systems. Some of them saw laws and lawmakers as opponents to outwit. Others among them didn’t take laws that personally – they just thought the law applied to other people.

Reading the books though, I find myself wondering how such seriously intelligent people could be so stupid. How could they think that they could operate the company on a giant Ponzi scheme forever?

They separated out economics from accounting, and separated cash from profit. The economic reality – the truth of the cashflow – was that they frequently cut unprofitable deals. You see, they booked all the future profits of a deal when it was struck regardless of when or whether the cash flowed in by using what is called “mark to market” accounting. Worse than this: executives were rewarded regardless of how profitable the deal turned out to be because they got their bonuses when the deal was signed.

As time went by, and a deal proved itself to be less profitable than they had said that it would be, Enron should have shown that as a loss. But they were immensely reluctant to do that, and of course the bonuses were long spent.

An example (please skip this bit if your eyes glaze over whenever you see numbers)

Let’s say they built a power-station at a cost of perhaps $1bn and that they struck a 20 year agreement to sell the power at a rate of £100m a year. By normal accounting methods, the power-station would show a cash income from year one, but would take 10 years to pay for itself. What Enron did was to show £1bn as profit in the first year, on the basis that this was how much profit they thought they’d make over the whole 20 years of the deal.

There are lots of problems with this, but here are two to start with:

It is much harder to show an increase in profits if you book all your profits in the first year. Using normal accounting rules, the power station would not clear its building costs until year 11, but from then on if you want to show $2bn profits, you only have to make $1.9bn because you’ve already got $100m coming in from the power station. But using mark-to-market accounting rules you are starting from zero every single year.

This effect is exacerbated if your power station does not in fact have an income of $100m every year. Say it only makes $75m. Then if you are using mark-to-market rules you should actually declare a loss on your your books of $25m every single year even when you’ve cleared your building costs and are actually in profit.

Ok, that was very technical thank you Aphra, but what makes it interesting?

The focus on the here and now, on the deal and not on its fulfilment, was the nub of Enron’s problems. But you cannot run a business not serve your customers, you cannot run a business and ignore the cash.

It seems simple doesn’t it? Simplistic even. And that’s what I find fascinating about Enron: how so many very clever people (and they were very clever – they came from Harvard and McKinsey and Arthur Andersen) how so many very clever people could be so incredibly stupid. If you have no cash income, you’ll have no business.

The second thing I find fascinating about Enron is how many people outside Enron happily pocketed the consultancy fees and commissions that Enron paid them to hold the cups and hide the peas in my previous metaphor. Enron asked the banks and other institutions to “invest” in “assets” which Enron would then “buy back”. That sounds like a securitised loan to me. Doesn’t it sound like a securitised loan to you? But Enron called it a sale, and booked the first half of the deal accordingly though I’ve no idea how they booked the second half. The banks and other investors were paid handsome fees for these transactions. Again, these are very bright boys indeed so it is no surprise that some of them worked out that the deals were not entirely as Enron was painting them, but as Kipling puts it “them that asks no questions isn’t told a lie”. There was money to be made.

The third thing that I find fascinating is how many of Enron’s corporate officers came from relatively humble backgrounds. Kenneth Lay (Enron’s long-term CEO) grew up on a mid-western farm. Rebecca Mark (who dashed around the world, riding on elephants, building power stations and running Enron International) was from the Midwest. Jeff Skilling (who was the inside guy to Lay’s outside guy and was briefly CEO) came from a blue-collar background in blue-collar towns. These were not decadent second- third- or fourth-generation American aristos, not Hiltons or Bushes or Kennedeys. The guys that ran Enron liked the part of the American Dream which gets very rich indeed, but ignored the part that learns all it needs to know at kindergarten.

The fourth thing I find fascinating is that every single person involved seemed to think that someone else was checking up on things. Enron blamed its auditors, Arthur Andersen, for letting them get away with it. Andersens blamed Enron’s financial officers for pushing the line too far. Wall Street was told that “Risk Assessment and Control” stopped risky deals from being cut. But the RAC employees claimed that they merely there to advised and could not veto. The fascinating thing is not that everyone blames everyone else, it is that everyone genuinely seems to think that they themselves were not in any way to blame.

And finally, and this is what really gets me, they were a bunch of fucking amateurs. Highly educated amateurs, admittedly, but none of them had actually run anything. Kenneth Lay’s CV comprised academia and a little bit of government work until he got given a company to run. He was a supreme politician and played good cop to Skilling’s bad cop. One cannot call Skilling an amateur: Harvard MBAs and McKinsey consultants are not amateurs, but he was a dangerously brilliant and lop-sided specialist who should never have taken on general management by becoming CEO of various subsidiaries and ultimately of Enron itself. Andrew Fastow, who became CFO, was not even an accountant: his background was financial instruments.

I think it’s the lack of self-awareness that fascinates me; and integrity is the sternest form of self-awareness. Were they venal or just un-reflecting? I don’t know.

So there you go. If you want a quick rattle through Enron’s last 200 days then read “The Anatomy of Greed” which was written by an outsider on the inside, an Enron employee who was kept in the dark and fed the same bullshit as everyone else. If you want to get down and dirty with the detail read “The Smartest Guys in the Room” which is fascinating and dispassionate especially where the authors’ shocked incredulity occasionally breaks through. If you want something online that’s more informative than Wikipedia go to Risk Glossary.

The second book is particularly thought-provoking, and I guess the thought it provokes the most is “just how unusual was Enron?”

9 responses to “Enron – a case of moral bankruptcy

  1. Sounds typically present-day USA to me. For ‘Enron’ read ‘Bush Administration’.

  2. Fascinatingly, Dubbya called Lay “Kenny Boy” – get this – because he was sucking up to Lay.


  3. It’s the stupidity of these people, even more than their venality and moral corruption, that is so dismaying.

  4. But anticant, people are stupid, in terms of what they can realistically organise/control compared with what they think they can. Even the most intelligent ones. I’m stuoid. You’re stupid. Human beings as a species have a tendency vastly to overestimate their abilities to understand and control things (there is lots of good scientific evidence to this effect).

    And when you also take into account people’s tendency to obey authority figures and to get into “us-and-them” situations where us is right, it’s not that surprising that the Enrons happen from time to time.

    BTW Aphra, I think the point you don’t mention in the Enron saga was the role of the press. It’s been a while since I read TSGitR but I suppose that books writte by journos might not major on the point. During Enron’s glory years, the company was constantly talked up by the financial (and indeed non-financial) press as a role model in all sorts of ways. Lay and Skilling got the colour supplement treatment. This all added to the “emperor’s new clothes” effect. If you didn’t “get” how wonderful Enron was, it was because you were not bright enough to understand or not connected enough to understand….hence all the consultants and MBAs and Wall Street insiders being dragged along, because there is nothing more a very clever very connected person hates more than the worry that they are actually not quite clever and not quite connected enough……

  5. Having worked at Worldcom during their little, er, accounting irregularity (11bn dollars worth) I’d say not unusual at all…

    I find it shocking that in the US they can enter chapter 11 bankruptcy which essentially cuts all creditors off from any chance of getting their money and can then carry on trading, getting to profit again and *never* paying those people back.

    Oh and I feel for the employees of both companies who saw their pensions and life savings disappear overnight. While, as you say, those in the know took their pennies home in a jar.

  6. I didn’t know you’d worked at Worldcom, kelli. How unfortunate, but how fascinating. I have very mixed feelings about Chapter 11, in theory and occasionally in practice organisations do trade through it. But….

    It’s good to see you back online Potentilla. As usual, I think you are right. I guess because I wasn’t really aware of Enron until it collapsed, I missed the importance of the press coverage. There clearly were a large number of people who could not afford to say “actually, we were wrong when we bigged up Enron on the front of our magazine or when we told you it was a Strong Buy”. The Cruver book does bring out the denial that the Wall Street analysts went through. I’ve only got about half way through the Smartest Guys, but I’ve got a couple of longish journeys the next few days so I hope to finish it soon.

    Thanks both for commenting.


  7. Worldcom traded through it and emerged from chapter 11 around 18 months ago IIRC. They’ve had two name changes now, but all those shareholding employees still have no pensions…

  8. Hi,

    I would just like to correct a few other comments.

    George Bush actually didn’t suck up to Ken Lay by calling him Kenny Boy. Kenny Boy was a phrase his wife Linda Lay used. George Bush used it in a sardonic way. Additionally, Ken Lay was closer to the elder Bushes than GWB. When President Bush had the opportunity to fill his energy cabinet, he did not choose Ken Lay.

    Additionally, it was President Clinton and his administration who stepped in on Enron’s behalf when they were building Dabhol. It was also under President Clinton that the California energy market was deregulated (a good thing, but others, particularly Democrats, believe to be a bad thing.)

    The events at Enron were not fraudulent. There was no fraud or conspiracy at Enron other than the projects undertaken by Andrew Fastow.

  9. Thanks for your comment caraellison. I’ll accept that neither of us can know whether Bush was being sardonic or ingratiating. Unfortunately everything I know about the man makes it easy for me to assume he lacks the intelligence to be sardonic. Fair point about Bush not using his patronage to promote Lay, though.

    I carry no flag for Clinton and I don’t know enough about deregulation one way or another to have an opinion on it, much less express one, but thanks for the information anyway.

    However, where I do disagree with you is about conspiracy; maybe there wasn’t a conspiracy, but there was so much individual back-covering and looking the other way that the results were conspiratorial. My image of Enron is however of a core of conspirators surrounded by huge numbers of people operating on denial and a willing suspension of disbelief.

    Your comment about the only fraud being in Fastow’s projects raises the interesting question of whether or not the legal boundaries are drawn in the right place, which is one of the questions I was asking. Mark to market accounting wasn’t illegal, but was it right? There’s a related question which I didn’t ask, which is if people’s moral boundaries are in the right place, do they actually need laws to restrain them?

    Regarding fraud and conspiracy, I’ve not been following it closely – what were Lay and Skilling convicted of?

    Thanks for commenting.


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