Enron: The Smartest Guys in the Room

I’ve been reading this extensive breakdown by Bethany McLean and Peter Elkind of Enron’s collapse after a colleague’s recommendation (based on my enjoyment reading Bad Blood). I found it fascinating how much of the classic image I have of corporate greed stems from the relatively recent collapse of Enron in 2001. Since I just missed the Enron collapse, being about ten years old at the time, I had assumed that these ideas had existed for much longer, but during the bull market of the 90s the image had yet to fully form.

There is too much detail in the book to summarise everything I’ve learned from it, but I wanted to pull out two specific pieces that will be front of mind for me for a long time to come. I’ve simplified some of the details here partially because there’s too much in the book to include here, and partially because I’m not familiar enough with the financial concepts to talk about them confidently. Apologies for any mistakes, but I hope the points still remain.

Mark to market accounting

Something that stood out to me when watching the film (before I read the book) was Enron’s use of mark-to-market accounting. This is where assets and liabilities are valued according to the current market price, rather than the price paid or value they have provided.

The example given with Enron was that when closing a deal they would book the entire value of the deal on the balance sheet at the time of signing. For example, if selling a contract to provide energy, worth $1m revenue a year for 20 years, they would book revenue of $20m at the time of signing. Traditionally this would have been booked as $1m each year of the contract. This practice looked great at first glance as Enron was booking significant revenues, and could show huge growth. The market and analysts loved this and it was reflected in their share price from the mid-90s until not long before their collapse.

When watching the film I had thought this whole practice sounded ridiculous; well obviously they must be a fraud I had thought. However the book goes into more detail…

Imagine a hedge fund. When buying a stake in a company on the stock market for $20m, that is worth exactly that at the time of buying. Recording it on the balance sheet as such is an accurate way to document the value now owned by the hedge fund. If the share price goes up by 10%, the hedge fund could book revenue of another $2m, because the value of their stake is now worth $22m. The flip side is that if the share price drops by 10%, they should book a loss of $2m as their stake is now only worth $18m.

This is fairly intuitive and easy to understand, and that’s (roughly) mark-to-market accounting. This is in fact so well understood that it’s considered a normal part of the Generally Accepted Accounting Principles (GAAP) in the US, a common set of practices for how to document accounting for investors, auditors, or the public.

Now imagine that this hedge fund traded energy futures instead of shares, but that we’re in the mid 90s so there isn’t a market for energy futures yet, and the hedge fund is trying to start a market for them. One could argue that this isn’t a materially different scenario, and indeed that’s what Enron’s position was. While they started out as strictly an energy company, owning gas pipelines and production facilities, they wanted to transform into a “gas bank” – creating a market for natural gas contracts that could be traded, to hedge and securitise energy services. This was so critical to Jeff Skilling’s vision for Enron when he joined, that he negotiated his employment contract to include a requirement for Enron to move to mark-to-market accounting so that they could work more like a financial institution than a traditional energy company.

Before reading the book, I hadn’t appreciated how close to reasonable the choice of mark-to-market accounting was. In many ways it really did make sense, especially since Enron was creating something new.

Unfortunately for Enron (and their accountants Arthur Anderson) with hindsight it wasn’t the right choice. Mark-to-market accounting works for shares and might be fine for energy futures, but much of Enron’s business was still traditional energy supply contracts where the practice didn’t make sense. Also mark-to-market requires the ongoing updating of the value of assets and liabilities over time, based on an accurate understanding of value. In many cases, Enron did not update their balance sheet with the new values of their contracts, and even when they did this was typically done with optimistic models and forecasts created internally with no oversight, rather a stock market value that a hedge fund would typically use.

This theme of Enron’s innovation being mostly reasonable on the surface continues throughout the book, however one of the main reason’s for their downfall was Enron’s culture of legality being equated to ethics – if it’s legal, it’s right. Ultimately Enron did a lot that was illegal, but much of their fate was sealed with legal actions (and those that weren’t sufficiently challenged by their risk team, accountants, or the SEC), that they believed were right to do.

There are many parallels with the present-day themes of disruption in Silicon Valley and the tech ecosystem, but in place of financial engineering run amok we see privacy/targeting and exploitation of workers.

Doubling down on failure

The second thing that stood out to me while reading the book was how throughout their history, even in their final months and days, Enron and their senior staff doubled down on errors of judgement further leveraging themselves and exacerbating their precarious position.

The main example of this is how Enron CFO Andy Fastow created multiple funds (each larger than the one before) that lent to Enron, with investment repayments guaranteed by Enron. Not only did Enron guarantee to repay the loans immediately should their credit rating be downgraded, but returns were also guaranteed by Enron shares, meaning if the share price fell to far, it would cost Enron far more shares to repay them. The worst part was that these two mechanisms – share price and credit rating – are intrinsically linked (both being proxies for confidence) such that should one go bad, it would be very likely that the other one would as well.

This all happened because of a culture that Enron executives may have called optimistic, but that many would have called arrogant. Arthur Anderson accountants and other Enron clients both spoke to this culture of arrogance – a feeling that Enron employees were better than everyone else.

It seems that much of this arrogance came from Jeff Skilling who had previously been a partner at the management consultancy McKinsey & Company. McKinsey already have a reputation for elitism, and arguably arrogance (although in my limited experience they seem good at what they do), so combined with Skilling’s own meteoric rise through their ranks it’s not surprising that this was amplified at Enron.

It’s also not surprising in hindsight that Skilling’s own sense of self-worth became entangled with Enron’s share price to the point where he ultimately left due to its decline and then attempted to re-join as he realised that the decline may not have been his doing after all (it definitely was).

For me, the most egregious example of the arrogance in Enron’s culture came from CEO Ken Lay, who had much of his extensive personal wealth tied to Enron in the form of shares, loans, and future bonuses. So much of his wealth was tied to it that his financial advisors encouraged him to diversify, but rather than selling Enron shares and putting the money into other investments he took out loans for investments that were secured against the value of his Enron shares. This leverage was yet another dangerous link to a share price based on artificially inflated numbers, and another example of a cultural belief that Enron was special and could not fail.

Ultimately, one of the messages I ended up taking away from the book was that not only was Enron’s culture a toxic and unpleasant one that reduced their effectiveness as a company, but the arrogance in their culture and approach being the best way to do things led to them doubling down on the worst aspects during their toughest times.

For anyone interested in or working in finance, I’d recommend Enron: The Smartest Guys in the Room as a detailed study in how not to operate, and common ethical pitfalls to avoid. For anyone interested in company culture and how it affects performance, it’s a fascinating read, documenting one of the clearest examples of that connection that I know of.